The Brazilian example

October 21, 2009

Brazil’s decision to impose capital controls has caused investors to howl. But a tax on foreign investment makes a good deal of sense for emerging nations seeking to stem inflows of hot money and slow a rising currency.

In the case of Brazil, action was needed. The nation has become a darling of international investors attracted by a combination of rising commodity prices, strong domestic consumption and sound macro policies. Overzealous traders were clearly becoming a liability.

The real is up by a third against the dollar so far this year — making it the strongest major currency in the world. Overseas interest has also helped catapult the stock market up about 75 percent. Aside from the obvious danger to Brazil’s exporters, enthusiasm from foreign investors is raising the risk of asset price bubbles.

On its own, the modest 2 percent tax on local bonds and stocks will not do much to calm the ardor of investors. A similar tax was in place in 2008 and did not prevent the real from reaching its highest level against the dollar of the decade.

Even so, the tax is a useful addition to the tool kit.

As a method for tempering currency appreciation, a tax on foreign investment has several advantages over buying dollars. Foreign exchange intervention can be costly for countries like Brazil. To avoid stoking inflation, intervention has to be offset by issuing domestic bonds.

For nations with high interest rates, this is a terrible deal. From its U.S. Treasuries, Brazil gets a tiny yield, with the three-month bill offering just 0.08 percent. Yet it has to issue bonds that pay out nearly 9 percent. A tax on foreign investments, by contrast, actually raises revenue.

For the same reason, such a tax may make sense for countries like India and South Korea that are paying dearly for their accumulation of dollar reserves. With foreign exchange reserves rising beyond a quarter of a trillion dollars each, the countries need to issue more bonds, and their costs quickly mount.

India has three-month securities that pay out 4.4 percent, while South Korea pays out 2.8 percent. A Brazil-style tax could at least help defray part of the expense.

For the United States, such taxes are the worst possible outcome. Foreign exchange intervention may hurt American exporters, but at least central bank purchases of U.S. Treasuries put downward pressure on their borrowing costs. By contrast an investment tax could end up damaging U.S. exporters and investors without helping U.S. Treasuries.

But assuming U.S. annoyance can be held in check, Brazil’s strategy is extremely sensible and worthy of emulation.

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Posted by Brazilian lady dating how to celebrity funny beach | NowGadget | Report as abusive

….. are you joking?? What school of economics or business came up with this one??? Answer: NONE

Posted by Joe Kurr | Report as abusive