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In praise of James Tobin; India, Indonesia or Korea, who’s next?

November 24, 2009

If only James Tobin had lived to see this day. The American economist was not only a big fan of government intervention in matters economic and financial, which this credit crisis has seen plenty of, but he was also the man behind the ‘Tobin tax’ that Brazil has just introduced on foreign exchange transactions.

James Tobin believed a small tax on speculative transactions was acceptable and a reasonable means for third world countries to garner some revenues out of foreigners who wanted to dabble in their markets.
It doesn’t stop with Brazil. Indonesia hasn’t introduced a Tobin tax, but is trying to close a loophole through which corporates borrowing through special purpose vehicles could evade local taxes. Both Taiwan and Indonesia have also targeted short-term foreign investments — Taiwan has banned foreign investment in time deposits while Indonesia is thinking of banning overseas investors from central bank bills.

In an environment of low interest rates, abundant liquidity and a voracious appetite for yield, Asian and other emerging markets have had to deal with massive capital inflows. Policy makers have almost grudgingly watched their property and equity markets propelled to higher highs by these flows. In economic parlance, there’s been a jump in broad money growth and the cash in excess of what is required to finance ongoing economic activities is finding its way into financial assets.

As this chart illustrates, there’s been a rapid increase in capital flows into Asia since the middle of 2009, accompanied by a sharp spike in share prices.

Central banks are running out of choices. They cant raise interest rates just in order to prick an asset bubble when industry and domestic demand is still weak. They have let their currencies rise to an extent, but further appreciation is undesirable. Until export demand in developed markets picks up or big neighbour China lets its yuan appreciate, any further gains in these Asian currencies will further hurt their already struggling exporters. As this chart shows, the gains in currencies such as the won and rupiah are already causing some discomfort.

Most central banks are intervening to absorb the dollars flowing into their markets, but that intervention merely replaces the foreign currency in the market with local currency, which finds its way into the asset markets. If central banks want to intervene to keep their currencies from rising, they also have to sterilise the local currency liquidity by issuing bonds.

The cost of sterilisation matters. For countries with interest rates close to those in the United States or developed markets, such as China, Taiwan and Hong kong, it is quite easy for them to intervene and then sterilise the resulting local currency liquidity by issuing securities, whose yield is also quite low. It is a different matter for an Indonesia or an India, where central banks are issuing securities at 6 to 9 percent in order to soak up excess balances in their markets.

This is where capital controls, either in the form of a tax like Brazil’s or outright quantitative bans like Indonesia’s and Taiwan’s, become an attractive policy option.

Who’s next in Asia? Because of the high “carry” and hence sterilisation costs, India and Indonesia and even Korea to some extent are prime candidates for capital controls of some form in Asia. The less likely are those with low interest rates, such as China, Taiwan or Thailand, which have massive current account surpluses but where low interest rates can support a heavy intervention-plus-sterilisation policy for a long time.

In the past decade or so, Asia has seen almost the entire gamut of capital controls. Malaysia’s was the most extreme when, faced with massive capital flight in 1998, it pegged the ringgit, closed its shores to foreign portfolio flows and banned offshore trade in its currency. Thailand’s case in 2006 was a case of heavy taxing, when portfolio flows of tenors shorter than a year were taxed 30 percent. More recently, Korea in 2008 used more or moral suasion and restrictions on onshore borrowing of foreign currencies.

This time however, the bitter after-taste of the Thai and Malaysian controls still fresh in their minds, most investors suspect capital controls will take the form of taxes and tweaks, rather than wholesale bans on entire asset classes or types of money.

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