Emerging 'hot money' battle may just work

Moves by emerging economies to staunch speculative foreign investment flows may succeed by simply tempting "hot money" to book profits on a stellar run over the past year, while long-term investors sit tight.

Brazil, wary of bubbles in its domestic markets and an export-squeezing currency surge, grabbed headlines on Monday by slapping a two per cent tax on net foreign purchases of local equities and bonds - and threatening more.

But Brasilia's move to limit the flow, which has seen the Bovespa stock index. BVSP more than double in dollar terms in the year-to-date and real climb more than 30 per cent, is far from an isolated case.

Last week, South Korea - watching year-to-date 40-per cent plus stock gains and won appreciation of over 20 per cent since March - said it was reviewing controls on foreign currency liquidity ratios at foreign banks.

"Moves like a two per cent tax in Brazil are simply not enough to make a difference to a medium-term investment decision," said Raffaele Bertoni, head of fixed Income for Europe and Asia at fund managers Pioneer Investments in Dublin.

"But it reduces a little bit the risk appetite for the asset class which in our view is already fair-valued," said Mr Bertoni, adding that moves by the bigger countries such as Brazil and South Korea may make it easier for smaller ones to follow suit.

"It may come at a time when it's right to be less aggressive about emerging markets."

A variety of other measures are being seen as part of the same trend to soak up the emerging flood - not least the steep rebuild this year of hard currency reserves via central bank intervention to limit local currency gains on the falling US dollar.

Turkey's constitutional court last week ruled foreigners should pay withholding tax on bonds and currency futures equal to that of domestic investors. Colombia has acted to cap 20 per cent peso gains in 2008 by halting repatriation of dollars by state firms.

The markets radar has been primed to such an extent that, on Thursday, South Africa's economic development ministry was forced to deny a local press report that it planned to "freeze" the rand exchange rate.

The reaction to these moves coincides with a more general stalling of the rally in risky assets worldwide - Brazil's move, for example, knocked some three per cent off the real in two days - but long-term fund managers remain sanguine.

"Ultimately if the long-term investment case is strong I doubt these controls will have a material impact on foreign capital flows," said Oliver Bell, senior investment officer at Pictet Asset Management in London.

And judging by that view, policymakers may achieve the best of both worlds - arresting runaway markets and deflating bubbles without discouraging long-term portfolio and bricks-and-mortar investors.

"There is a risk we do see further signals from emerging central banks (to cap currency gains), but unless we see a fundamental shift in global imbalances, interest in emerging assets is likely to remain very strong," said Manik Narain, strategist at Standard Chartered in London.

After the shock of 2008, when all "risky" investments were sold indiscriminately for cash following the collapse of Lehman Brothers, emerging markets at large have been quickest to recover and have outperformed all other asset classes.

The money flood has swelled in recent weeks and months as economic growth rebounded sharply in the third quarter in countries which escaped the severe banking implosions and domestic credit crunches suffered by many Western economies.

For example, MSCI's main emerging markets index actually troughed in October of 2008 - unlike Western markets which bottomed in March of this year - and has risen some 120 per cent over the intervening 12 months.

JPMorgan's index of emerging market sovereign credits shows the average yield premium over equivalent US Treasury bonds more than halved to about 300 basis from as high as 690 basis points at the start of the year.

The flows behind these price moves illustrate the pressure.

Data from EPFR shows the $967 million absorbed by emerging markets bond funds in the week to October 14 was the highest since EPFR began weekly data in 2001. $4 billion of net flows into emerging equity funds was the biggest since December 2007.