Strong economic growth in Latin America fueled largely by commodity exports has ignited growth more generally across the region — a big change from recent years of stagnation. That success in turn has attracted a raft of foreign investment looking to take advantage of the region’s resurgence.
But as welcome as those outside investments may be, the rapid rate of inflowing capital can have an ugly downside. It can push up the value of local currencies, wounding competitiveness, and crank up inflation through the monetary expansion it causes.
This is true even though most of the inflows into Latin America today arrive as foreign direct investments (FDI), which are generally long term and favored by host countries over more fleeting “hot money” investments in short-term assets such a stocks. That hot money can more quickly reverse course, exit the country, and cause sudden, deep plunges in key markets.
Still, the amount and rate of fund flows into the region is forcing up currencies and interest rates, and countries have responded with various forms of capital controls in an effort to manage the flows. Not long ago, such controls were viewed as a big impediment to economic growth. But more recently those views have eased some, and even the International Monetary Fund last month said such controls can be justified under select conditions.
FDI into Brazil, for example, has been growing faster than any other kind of investment. Brazil’s central bank has just forecasted that FDI will more than double this year over 2010 to $55 billion. In the first four months of 2011 alone, FDI climbed to US$37 billion.
Some examples of that investment: Global oil and oil services companies are spending heavily in Brazil’s newfound oil wealth off the coast of Rio de Janeiro. Other foreign industry is eyeing Brazil’s growing tech-savvy middle class. For example, Foxconn, a Taiwan-based manufacturer of mother boards and video cards, is expected to announce a $12 billion investment in Jundiaí, São Paulo, to build a facility to manufacture components used in Apple iPads and iPhones.
One result of all of this foreign interest is that the real has appreciated rapidly against the dollar over the past two years, to the detriment of the country’s exporters. Brazil “is almost being punished for being so attractive to fund managers and corporate investors,” says Wharton management professor Mauro Guillen. “Its currency gets overvalued and the central bank gets scared and raises interest rates. But that just ends up attracting more investment into fixed income and hurts small and mid-sized companies, which don’t have the ability to tap offshore loans like big Brazilian companies can.”
Brazil, Chile and Colombia have each taken a different approach to these problems, with varying levels of success. Brazil has raised taxes on foreign capital inflows, while Chile, after intervening in currency markets to weaken its peso, now looks willing to let the currency appreciate according to market dictates. As for Colombia, its currency has been appreciating against the dollar this year even faster than several other Latin American currencies, including the real. The country is “in the same situation as Brazil” because of high commodity prices and demand for its oil and coffee, Guillen points out. For now, Colombia’s strategy has been to intervene in currency markets to try to take upward pressure off the Colombian peso.
To read more about how Brazil, Chile and Colombia are handling foreign investment inflows, see this article in Universia Knowledge at Wharton: Closing the Floodgates: Latin American Capital Controls Kick In.