Speculation regarding a Tobin-type tax, which was proposed to dampen speculation in the foreign exchange market four decades ago, refuses to go away. The so-called Leading Group of financial experts from Brazil, Japan, France and Britain has strongly pitched in favour of a Tobin tax on foreign exchange trades — “ as the most appropriate source of revenue” to garner $33 billion to fund development projects and bring nations together in a single effort to combat poverty.
Of late India’s policy makers, too, have been making statements about its desirability or feasibility in the domestic context. Dr Y V Reddy, former Reserve Bank of India (RBI) governor, remarked that “it is an issue that was considered a sacrilege a few years ago… but in Europe there was a strong case for Tobin tax… Public policy should keep the Tobin tax open. It should insist that it has the option and that (by) itself will make the financial markets conduct business with a certain caution”.
The shifting fortunes of this proposal by the late Nobel prize-winning economist James Tobin is a fascinating study in the history of ideas. The tax was intended to throw sand into the wheels of currency speculation. This idea was headed for obscurity till it was resurrected by the anti-globalisation movement after the Asian currency crisis of 1997. It once again became fashionable after the 2008 crisis, with French President Nicolas Sarkozy and UK’s former premier Gordon Brown advocating it.
The buzz around a Tobin tax persists in India because the economy faces the clear and present danger of a flood, including the danger of sudden halts of capital inflows. Policy makers, especially those at the central bank, are concerned about the destabilising consequences of speculative inflows flooding in and out of the system — which is bound to affect the robust growth dynamic of the Indian economy. Such inflows are typically pro-cyclical, rising in good times and falling in bad times.
Net capital inflows have been surging in the Indian economy, hitting a peak of $107 billion in 2007-08 before plunging to a low of $7.2 billion in 2008-09 at the height of the global crisis. With a recovery underway since then, capital inflows, too, have revived to $53.6 billion in 2009-10. The worry is that such inflows — which exceed what is needed to finance the current account deficit — complicate the task of managing the exchange rate and conducting an independent monetary policy.
Capital inflows — income, portfolio investments and aid barring foreign direct investments — have been observed to have a positive impact on the appreciation of the real effective exchange rate in developing economies and undermine their competitiveness (see the IMF working paper titled “The impact of capital and foreign exchange flows on the competitiveness of developing countries” by Damyana Bakardzhieva, Sami Ben Naceur and Bassem Kamar, July 2010).
A sudden stop of capital inflows due to the global crisis threatens a prolonged crisis for developing economies that are more integrated with the global economy. The re-pricing of credit risk increases the cost of external financing, inducing a sharp decline in output and domestic inflation and a depreciation of the domestic currency, argues another IMF working paper, “External finance, sudden stops, and financial crisis: what is different this time?” by F Gulcin Ozkan and D Filiz Unsal, July 2010.
The talk of a Tobin-type tax keeps surfacing regularly in India as policy makers are concerned about another surge in capital inflows — considering the country’s booming GDP growth when the recovery of the world economy remains fragile. According to Duvvuri Subbarao, RBI governor, the prospect of India becoming an outlier in the withdrawal of post-2008 crisis monetary stimulus measures could also trigger more net capital inflows attracted by interest rate differentials.
To curb excessive short-term fund inflows, a Tobin-type tax has been suggested for India, on the lines of what Chile imposed during the 1990s. To protect its economy, the latter discouraged short-term inflows by requiring foreigners to make non-interest bearing deposits with the central bank. But this measure did not reduce the aggregate volume of capital inflows. The currency also appreciated, according to the work of Professor Sebastian Edwards of the University of California.
To be sure, India’s policy makers are fully aware of the problems in imposing a Tobin-type tax: it can also be evaded through derivatives. It reduces liquidity in the markets. The scope of the tax also needs to be continually widened, resulting in inefficiencies. But it is interesting that even after categorically stating “we have not so far imposed nor are we contemplating one” such a measure, Subbarao significantly added that “it needs reiterating that no policy instrument is off the table”! All of this could change in a trice if a tsunami of capital heads India’s way due to shocks in the world of high finance. The upshot is that for all the doubts regarding its efficacy, Tobin’s proposal remains very much alive and kicking in the Indian context.
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