Re: Tobin tax

["Ronald Calitri" <calitrir@xxxxxxxxxxxxx>]

It is only available by mail now; but I suggest a reading of Salih Neftci's
recent paper, "FX Short Positions, Balance Sheets and Financial
Turbulence."(10/98) It can be ordered from the Center for Economic Policy
Analysis
(CEPA) off the www.newschool.edu website.
The argument essentially, comes from Neftci's consideration of the case of
Thailand, where the following cascade is argued. 1. First tier investment
banks borrowed dollars to loan bhat locally. Their 'innovative' process
offered substantial returns above currency depreciation. 2. Local
'favorites,' larger clients, branches, began the same dealings,
irrepressibly attracted by the profit of FX positions. 3. Speculators (N.
argues they were
part 'emulators' from the local elite, part financiers with only
'phone-lines' for overhead costs simply upped the ante.

However, Neftci also argues that none of this need lead to a financial
crisis = ie devaluation, unless there is a current account deficit reducing
Central Bank reserves to less than that of the open FX positions: "Hence the
CB is now obligated to maintain the exchange rate regime as long as it can.
This will be seen as some sort of short-term insurance by other market
players, who may join the process." (p.22)

Neftci's point is this can (and does) go on for years. He does not add that
the slow depreciation continually places 'players' unable to hedge FX into a
lower absolute return category. So the question boils down to a political
economics of internationalization being accompanied by intensified domestic
income inequality. Under this scenario the "volatility" of global financial
markets is not the danger so much as the inevitable sorry results for the
financially powerless.

Fixing a situation of this order is entirely a different kettle of fish -
the proper solution not a bandaid tax but getting down to why the
unrealistic profit expectations of FX continue to be met.

Chiao,
Ronald Calitri

-----Original Message-----
From: Henry C.K. Liu <hliu@xxxxxxxxxxxxxx>
To: POST-KEYNESIAN THOUGHT <pkt@xxxxxxxxxxxxxxxx>
Date: Monday, April 05, 1999 10:51 PM
Subject: Re: Tobin tax


>It was John Tyler who wrote:
>"Shortly after the collapse of the Hong Kong market in 1997, Robert
Samuelson
>wrote a long article in Newsweek on the Asian crisis.  He pointed out that
of all
>the alarms he has seen over many years, this is one that could turn out to
be
>serious, and he recommended serious consideration of the Tobin tax as a
remedy."
>
>Still, Messrs Hummel's and Veeder's defense of the Tobin tax as an
effective
>preventive measure deserves a response.
>It was in 1978 that James Tobin first proposed the idea of a tax on foreign
>exchange transactions that would be applied uniformly by all major
countries. A
>tiny amount (less than 0.5%) would be levied on all foreign currency
exchange
>transactions to deter speculation on currency fluctuations. When Tobin
first
>proposed the idea of a punitive tax on premature withdrawal of foreign
capital,
>the global financial markets were very different than they are today, both
in
>size, volume and velocity of flow.  The relationship of direct investment
to
>structured finance was also almost non-existent. Clearly, the concept is
>inadequate today even as a preventive measure.
>
>A punitive tax on capital flow works in both directions.  It slows inflow
as well
>as exit.  In that sense it is conceptually similar to using birth control
to
>prevent cancer.  It is a measure that aims at removing the problem rather
than
>curing the problem.
>International capital flow per se is not undesirable, if one accepts the
>neo-liberal view of financial capitalism and globalization (which is
another
>debate).  What is undesirable is when sudden and massive capital flow is
caused
>by profit incentives that are unrelated to the soundness of the investment
or the
>market fundamentals of a region, i.e. foreign exchange speculations.  The
Asian
>financial crises were not caused by "bad investments" as much as they were
caused
>by international commercial banks viewing their borrowers merely as
vehicles for
>easy profit in currency speculation.  The collapse was more financial than
>economic.
>What is needed is a new international financial architecture that makes the
flow
>of funds and the foreign exchange/interest rates arbitrage a neutral
activity
>that reassign profit back to end-use investment in real economic
development.
>The Tobin tax has not been conceived for the purpose and thus is
ineffective even
>as a preventive measure under these conditions.  All it does is to assign
an
>additional cost that investor and speculation can easily factor into their
>initial manipulative calculations.
>
>Similarly, economic thinking prevailing immediately after WWII had deemed
>international capital flow undesirable or unnecessary, drawing lessons from
the
>1930 depression.  When those conditions changed, the Bretton Wood system of
fixed
>exchanges collapsed.
>Beginning in the early 1960's, with the growth of Euromarkets where banks
in one
>European country could take deposits and make loans in currencies of other
>countries, the tight controls of international flow of capital set up by
the
>Bretton Woods system of fixed exchange rates after World War II were
effectively
>bypassed.  When the fixed exchange rate system set by Bretton Woods finally
broke
>down, with a gold-backed US dollar that became fatally wounded in 1973 by
decades
>of US fiscal irresponsibility, the developed countries abandoned capital
controls
>officially.  In the late 80's, many developing countries followed suit.
>
>In the last decade, daily turnover of foreign exchange grew over one
hundred fold
>to over US$1.5 trillion from US$190 billion at the beginning of the decade.
By
>1996, some US$350 billion of private capital flowed into emerging markets,
a
>seven fold increase in 6 years.  The bulk of this inflow went through
global
>commercial banks.  Since July 1997, the bulk of the outflow has left in the
form
>of sudden withdrawal also through commercial banks.
>For the past two decades, technical imbalances between interest rates set
by
>different central banks for funds in different currencies distorted capital
flow
>around the world from economic fundamentals.  The resultant inflow of
capital
>into Asia through inter-linked financial markets around the globe
outstripped the
>region's viable absorption rate.  Financial institutions took advantage of
low
>cost funds denominated in currencies of select countries, namely Japan,
Germany
>and the United States, to make loans at higher interest rates denominated
in
>local Asian currencies.  These institutions sought to strategically profit
from
>recurring technical imbalances in global finance by assuming currency
risks,
>rather than from traditional direct investment returns.  Economists call
this
>activity international arbitrage on the principle of open interest parity.
In
>banking parlance, this type of activity is known as "carry trade".
>
>This abusive speculation was by no means limited to emerging economies.
>Corporation in developed economies routinely engaged in global financial
and
>stock manipulative speculation at the expense of sound production
strategies.
>The public announcement of plans to open new factories in Asia predictably
lifted
>share value in home markets, regardless of such factories being risky
>loss-makers, for the loss would be more than covered by the increase market
>capitalization resulting from the publicity of a presence in an emerging
maarket.
>
>Corporate borrowers in Asia, attracted by low rates in some foreign
currency
>loans, have also assumed currency risks, at times even bypassing local
banks to
>borrow directly overseas.  Borrowers, anticipating asset inflation brought
by run
>away growth, also succumbed to the irresistible temptation of borrowing
short
>term to finance long term projects, thus adding to the risk they assumed.
>Simultaneously, many Asian banks have taken local currency deposits at low
saving
>rates (in Hong Kong at times at negative interest rates - dpositors pay the
bank
>to keep their money) to invest overseas in risky foreign currency
instruments
>yielding higher returns, engaging in carry trade.  Local banks in turn have
>replenished the depleted local capital pool with low-cost foreign currency
loans
>from international banks, taking on both economic and currency risks.
>
>Borrowing low and lending high is the basic business of banks and there is
>nothing wrong with it if the activities occur within a well regulated
market of a
>bank's domicile community.
>With the advent of global banking however, the unregulated
internationalization
>of finance has created perilous systemic stress.
>Banks began to act as international loan brokers, profiting from interest
rate
>spreads between local and foreign funds, often booking the risk premium
added to
>over-valued currency interest rates as legitimate loan profits.  These
banks also
>began to maximizing their profits by maximizing loan volume, abrogating
their
>traditional economic function as responsible financial pillars of local
economies
>to ensure the productive allocation of capital.  In time, local banks
de-coupled
>their business self-interest from the economic impacts of their loans on
the
>local economies, because they hedged the risk in such loans by passing it
to
>overseas hedge funds which became the real loan originators to whom the
banks
>themselves lend the funds.  Western and Japanese international banks in
turn
>provided funds to the local broker banks in Asia whose credit ratings were
>considered acceptable because the borrowers' exposures were hedged by
instruments
>designed to transfer risk to other international institutions.
>In effect, the widespread transfer of business risks into currency risks
forced
>the governments of the affected currencies to become lenders of last
resort.
>This is the real economic effect of Hong Kong's and other Asian currency
peg to
>the US dollar.
>
>To increase returns, banks also creatively skirt regulation through
structured
>finance devises such collateralized mortgage obligations (CMO) which
releases
>pressure on capital requirements.  CMOs are essentially new junior debts
secured
>by old senior debts that takes advantage of the theory of large numbers.
>Similarly, corporations issue convertible bonds that do not appear on the
>corporation's balance sheets but expose the borrower to instant repayment
>requirements should its share value drop below the specified amont.  So in
an era
>of allegedly increased transparency, layers of opaqueness are introduced
through
>structured finance.  The unbundling of risk acts as a disguise of risk.
>
>Hedging does not eliminate risk, it merely passes risk along to other
parties.
>In fact, complex hedging schemes, with the effect of reducing the risk
exposure
>of individual lenders and inflating the credit worthiness of the hedged
>individual borrowers, when widely practiced, actually increase systemic
risk
>exposure, initially of regional financial systems and ultimately of the
global
>system.  Yet the soundness of financial institutions continue to be
assessed
>singularly without regard to counterparty credit worthiness and the
breakdown of
>insularity within national borders, while financial markets have become
>intricately linked globally.  A poor credit rating seldom means the denial
of
>credit.  It only means a higher interest rate which actually attracts more
eager
>lenders who rationalize that the high risk has been compensated for by the
>increased rate.  Junk bond rates are calculated from historical
industry-wide
>default frequencies. Through extensive hedging, private financial risks
have been
>largely socialized globally.
>
>The ingenious layering of protection against risk, while providing comfort
to
>individual players, buys such comfort at the expense of the security of the
total
>global system.  At some point, the strained circular chain breaks at the
weakest
>link and panic sets in.
>That break occurred in Thailand on July 1, 1997.
>
>When the Asian financial crises began in Thailand, it had not been
triggered by
>hyperinflation or a sudden drop in corporate earnings.  It was triggered by
a
>collapse of an over-valued Thai currency pegged to the US dollar the
massive
>selling of which drained foreign exchange reserves.  Generally, in
hindsight, it
>is indisputable that the conditions leading to the Asian financial crises
were:
>unregulated global foreign exchange markets and the widespread
international
>arbitrage on the principle of open interest parity (carry trade); short
term
>debts to finance long-term projects; hard currency loans for project with
only
>local currency revenue; overvalued currencies unable to adjust to changing
market
>values because of fixed pegs and above all instant massive movement of
funds that
>is susceptible to herd panic.
>
>Under these conditions, when there is a threat of currency devaluation
caused by
>a dwindling of reserves, the whole financial house of cards collapsed,
causing
>havoc in connected economies in a chain reaction, called contagion.
Collapse of
>one currency then quickly grew into regional economic crises within weeks
and
>turned global that eventually hit Russia and then Brazil.
>
>Because of this circular system of global hedging, the economic crises in
Asia
>inevitably have spread worldwide.  The regional crises, each with unique
local
>characteristics, are merely early symptoms of a ticking global time bomb
>constructed out of the complex calculus of  inter-linked financial markets
in
>which countless individual credit risks are legally masked as sound
transactions
>through sophisticated hedging.  Derivatives, financial instruments which
derive
>their value from other underlying financial instruments or benchmarks such
as
>stock indices or exchange rates, are the cards in the fragile house of
cards
>built by a financial specialty known as "structured finance".
>
>By far the most significant event in finance during the past decade has
been the
>extraordinary development and expansion of financial derivatives.
>International finance in recent years has been saturated with disastrous
and
>scandalous abuses that clearly and repeatedly epitomize the deficiencies of
the
>unregulated global inter-linking of financial markets.
>Speculators have been blamed for precipitating the run on Asian currencies
that
>started the financial
>crises.  Yet speculation and risk management are two sides of the same
coin.  At
>the opposite end of a prudent hedge, a speculator is required.  In a
structurally
>flawed system, perfectly honorable businessmen or institutions individually
true
>to high ethical and financial standards, can unwittingly participate in
systemic
>games of dubious value.  Data on the now 20-months-old Asian financial
crises
>show that currency hedging individually by sophisticated businesses and
alert
>government bodies, domestic and foreign, as protective measures against
foreign
>exchange exposures in both debts and revenues, have been mostly responsible
for
>the sudden currency turmoil in the region.  In international finance, a
game
>of musical chair in financial risk is in full force in which the players
are
>handcuffed together through inter-linking hedges.  This game can cause
serious
>systemic rupture when the music stops.
>
>Specifically, the increased risk associated with a financial environment
which
>profits from instability characterized by abrupt and unpredictable change
and
>flux, has created a demand for financial instruments to protect against
that
>risk.  These instruments, generally called derivatives, can be defined
simply as
>aggregated or "bundled" contractually created rights and obligations, the
effect
>of which is to create a transfer or exchange of specified cash flows
between
>counterparties of coupled needs at defined future points in time.
>
>The size of the invisible money pool created by financial derivatives is
now many
>times (no one knows how many) the amount of M3.  One firm alone (LTCM)
commanded
>open positions of US$1.2 trillion financed by 100-fold leverage.  That is
the
>entire daily transactional value of the world's foreign exchange
>markets.  Another hedge fund (Tiger Management) can suffer an asset
evaporation
>(loss) in the amount of US$20 billion in 6 hours by a 10% appreciation of a
>single currency (yen) against the USD.
>At year-end 1998, U.S. commercial banks, the leading players in global
>derivatives markets, reported outstanding derivatives contracts with a
notional
>value of $33 trillion, a measure that has been growing at a compound annual
rate
>of around 20 percent since 1990.
>Of the $33 trillion outstanding at year-end, only $4 trillion were
>exchange-traded derivatives; the remainder were off-exchange or
over-the-counter
>(OTC) derivatives.
>On a loan equivalent basis, a reasonably good measure of such credit
exposures,
>U.S. banks' counterparty exposures on such contracts are estimated to have
>totaled about $325 billion last December. This
>amounted to 6 percent of banks' total assets way above the equity
requirement
>level.  What's more, these credit exposures have been growing rapidly, more
or
>less in line with the growth of the notional amounts.
>
>A Bank of International Settlements survey for June 1998 estimated that
size of
>the global OTC market
>at an aggregate notional value of $70 trillion, a figure that doubtless is
closer
>to $80 trillion today. With allowance made for the double-counting of
>transactions between dealers, U.S. commercial banks'
>share of this global market was about 25 percent, and U.S. investment banks
>accounted for another 15 percent.  While U.S. firms' 40 percent share
exceeded
>that of dealers from any other country, the OTC markets are truly global
markets,
>with significant market shares held by dealers in Canada, France, Germany,
Japan,
>Switzerland, and the United Kingdom.
>
>Now, please tell me how a Tobin tax can prevent all these forces from
heading
>toward disaster.
>
>Henry C.K. Liu
>
>
>"William F. Hummel" wrote:
>
>> But no one claimed the Tobin Tax would have prevented the capital flight
>> problem.  The question is whether it would have helped prevent the
conditions
>> that led to the problem.
>>
>> >In October 1997, the HK markets collapsed as a result of its good
liquidity
>> >- investors were selling good HK assets to raise funds to meet margins
on
>> >their collapsed investments in the less liquid markets elsewhere in
Asia.  A
>> >Tobin tax, which tends to work to discourage short term capital movement
>> >under more normal circumstances, would not have slowed fund outflows in
fire
>> >sales.  It would only have the effect of adding a small premium for HK's
>> >liquidity, and might actually further exacerbate the situation.
>>
>> Again, you are implying the Tobin tax cannot stop a panic.
>> Obviously it cannot.  But that is not a critique of the tax.
>>
>> >The tumult of the HK markets in August/Sept of 1998 was caused by the
>> >manipulation by hedge funds exploiting an overvalued HK dollar pegged to
the
>> >US dollar through the mechanism of a currency board which required rises
in
>> >local interest rates as HK dollars come under pressure from massive
selling
>> >by hedge funds which at the same time shorted HK equity in the futures
>> >markets. The small size of the HK economy and its markets were ideal for
>> >manipulative foiling of the normal market forces.  For every 1,000
points
>> >drop engineered by the hedge funds, they stood to profit by US$1
billion.
>> >The Heng Seng index was pushed down from 10,000 to 6,600 before the
>> >government intervened with US18 billion buying HK shares in one day.
Again,
>> >a Tobin tax would have zero impact under that situation.
>>
>> >The global currency regime requires a fundamental overhaul.  A simple
Tobin
>> >tax is like trying to fight a raging forest fire with a bottle of
>> >Pellegrino, or giving a terminal patient asperin.
>>
>> Agreed that a fundamental overhaul is required.  Just as heart
>> surgery is required for an otherwise terminal heart condition.
>> Are you suggesting that aspirin should be abandoned because it
>> doesn't cure a bad heart?
>>
>> William F. Hummel
>
>