Thoughts on Brazil & the 120-Club

The very prestigious 120-Plus-Reserves-Club has a new member: Brazil. The first Latin Nation to be admitted will now cavort with Asian icons --China, Japan, Korea, Hong Kong, Taiwan India and Singapore--- and with emerging Europe’s Russia. These very few countries now hold over US$4 trillion in the form of official reserves.
Not only are reserves high, but the pace of accumulation has accelerated in the past (very) few years.
This means two things at the same time.
First, it means many countries are revealing their monetary policy preferences quite clearly: floating is simply not the monetary regime a large number of countries feel happy with. Rather, revealed preferences show that many countries abhor appreciation and are willing to put up a good fight.
Second, it is also a constraint posed on all other policy variables, and it gets increasingly stronger as a constraint as the size of accumulation rises. Failure to sterilize massive FX interventions, for instance, tends to heat things up and in some countries (China) the added heat can be too much. But, alas, sterilization sometimes reminds Macarena of a dog biting its tail. Foreign investors want domestic money in order to buy all kinds of domestic assets, not just Government debt. So if you want them to hold only debt, you have to pay a price, i.e higher interest rates. So all asset classes become more attractive, so more foreigners want them, and the cycle begins anew…
Some people think that by using capital controls authorities can decouple exchange rates from interest rates, i.e decouple themselves from the world and from all its impolite and improper preferences. The evidence is not there to support this idea at the macroeconomic level, quite the contrary. Regarding the microeconomic effects of capital controls, its effects on firms,… let´s put it in the words of Kristin Forbes:

“First, capital controls tend to reduce the supply of capital, raise the cost of financing, and increase financial constraints (…). Second, capital controls can reduce market discipline (…) leading to a more inefficient allocation of capital and resources. Third, capital controls significantly distort decision-making by firms and individuals, as they attempt to minimize the costs of the controls or even evade them outright. Fourth, the effects of capital controls can vary across different types of firms and countries, reflecting different pre-existing economic distortions. Finally, capital controls can be difficult and costly to enforce, even in countries with sound institutions and low levels of corruption”

So let us sum it up: the most important emerging market economies do not take freely floating exchange rates to heart and prefer to fight appreciation by seriously constraining all other policy instruments, i.e surrendering a large chunk of their hallowed monetary independence.
Rather than embarking themselves on the perilous trail of capital controls, countries have two more intelligent options.
Number one: give up on intervention and allow the currency to float. Who knows, in these post modern times? They may even receive a pleasant surprise, finding out that their currency is already at or below (pdf) equilibrium!!.
Number two: go ahead and establish very hard pegs, surrendering what little is left of monetary independence anyway and assuring stable interest rates and breathing space for the private sector.