RIO DE JANEIRO/LONDON, Jan 29 (Reuters) - Emerging market currencies slumped on Wednesday as the U.S. Federal Reserve cut back further on monetary stimulus, offsetting aggressive interest rate hikes by Turkey and South Africa. Stock and foreign exchange markets from Istanbul to Sao Paulo remained under stress, with the Turkish lira staging a short-lived rally that lost steam as investors braced for the Fed's widely-expected decision to reduce its bond purchases by another $10 billion. Turkey's massive monetary tightening put pressure on the most fragile developing countries to follow suit to prevent jittery investors from running for the exits. But not even higher returns were enough to stop the exodus as the Fed continued to mop up the easy money that had been flooding emerging markets over the past several years. "Emerging markets in general will have to offer significantly higher funding costs in order to stabilize the dramatic change we are now seeing in net portfolio flows in the asset class," Citi FX strategist Ishitaa Sharma said in a note. The South African rand was down more than 2 percent to 11.21 per dollar even after the country's central bank raised interest rates for the first time in almost six years, bringing its benchmark rate to 5.5 percent from 5.0 percent.
In Turkey, where the central bank raised all of its interest rates in dramatic fashion, the lira initially rallied more than 3 percent but eventually gave up gains before recovering slightly. It last traded 0.45 percent stronger at 2.243 per dollar. "The Turkish rate move was more aggressive than many people had expected. That was the good part of the story," said Ulrich Leuchtmann, head of currency research at Commerzbank in Frankfurt. "But the market had to force this activity. There is still a fear in the market that the central bank does not have a reaction function." The moves by the central banks of Turkey and South Africa followed massive currency sell-offs caused by the prospect of a further reduction in U.S. stimulus that sucked investor cash out of the most vulnerable emerging economies. Investors deem real interest rates in these markets too low to compensate for growing economic and political risks. With Brazil, Turkey, South Africa and India all holding elections this year, policymakers are likely to be wary of hiking rates too much to avoid damaging economic growth. Turkish Finance Minister Mehmet Simsek addressed one of those concerns on Wednesday, saying that economic growth will not be severely damaged by the rate hikes and that it is too early to adjust the government's forecast of 4 percent growth this year. The rate increase follows similar moves across the developing world, with India unexpectedly raising rates this week and Brazil and Indonesia already in policy-tightening mode. Brazilian officials have sought to distinguish Brazil from other emerging markets in recent days, reiterating the government's commitment to sound fiscal and monetary policies. On Wednesday, a member of President Dilma Rousseff's economic team stressed that the central bank's tightening cycle was aimed at curbing inflation, not currency volatility.
LATIN AMERICA UNDER PRESSURE Latin American currencies resumed a broad sell-off, with the Argentine peso sliding 2.33 percent on the black market to 12.85 per dollar and the Mexican peso dropping nearly 1 percent after two straight sessions of gains. The Brazilian real closed 0.3 percent weaker at 2.4324 per dollar right before the Fed's decision as investors worried about the impact of the recent emerging market turmoil on Brazil's already shrinking economic growth prospects. In the futures market, however, the real extended losses following the Fed's announcement, with the contract for next month trading at 2.44 per dollar . The debacle of the Argentine peso's official exchange rate, which last week slumped the most since the country's 2002 financial crisis, is expected to shave at least 0.2 percentage points off Brazil's gross domestic product this year, Nomura forecast in a research note. Argentina is an important trade partner for Brazil and a key market for Brazilian companies. The real's losses were cushioned, however, by expectations that the central bank may soon step up its forex interventions as the currency nears a six-year low. Brazilian policymakers have been intervening in the market investors are also pricing in another aggressive interest rate hike of 50 basis points next month that would take the benchmark Selic rate to 11 percent, according to calculations based on the domestic yield curve. "With bad news at home and the anxiety coming from the Fed, folks are bracing for the worst-case scenario," said Reginaldo Galhardo, a manager at the currency desk of Treviso brokerage in Sao Paulo. "The market also is speculating about when the central bank will increase intervention to support the real." Emerging market stocks were also volatile. The main MSCI emerging market index rose 0.25 percent off 4-1/2 month lows, but the Latin American portion of the index slid nearly 1 percent.
Key Latin America stock index and currency prices at 1912 GMT
Stock indexes daily % YTD % Latest change change MSCI LatAm 2,876.50 -0.99 -9.23 Brazil Bovespa 47,556.77 -0.59 -7.67 Mexico IPC 40,751.42 0.22 -4.62 Chile IPSA 3,419.50 -1.94 -7.56 Chile IGPA 17,046.99 -1.75 -6.47 Argentina MerVal 5,675.22 0.25 5.27 Colombia IGBC 12,009.48 0.19 -8.12 Peru IGRA 15,481.97 -0.97 -1.72 Venezuela IBC 2,796.98 -0.71 2.21 Currencies daily % YTD % Latest change change Brazil real 2.4324 -0.28 -3.11 Mexico peso 13.3900 -0.98 -2.69 Chile peso 549.0000 -0.60 -4.17 Colombia peso 2007.0000 -0.22 -3.74 Peru sol 2.8220 0.00 -1.03 Argentina peso 8.0000 0.12 -18.84 Argentina peso 12.8500 -2.33 -22.18