Tobin-type tax on inflows mooted

RBI REPORT ON CURRENCY & FINANCE: 2002-03

Reserve Bank of India (RBI) has suggested taxing foreign exchange inflows as a means to better manage large capital inflows. In its Report on Currency and Finance released today, the central bank proposed several policy measures including imposition of a 'Tobin' type tax.

Tobin taxes are excise taxes on cross-border currency transactions, and are used to tame currency market volatility and restore national economic sovereignty.

In the last couple of months, foreign exchange inflows have increased at an average of over $ 1 billion on a weekly basis.

This is as opposed to capital flows rising at an average of $ 5.8 billion per annum in the 1990s since the economic reforms and India's move towards globalisation.

According to RBI's report, capital inflows rose to an average of $ 12.1 billion in 2002-03, "resulting in a large and growing surplus in the overall balance of payments."

The progressive globalisation of the Indian economy has seen a dramatic increase in the country's reserve money.

Net foreign assets of RBI has increased from Rs 6,068 crore at the end of March 1990 to Rs 4,68,745 crore by January 16, 2004.

With the central bank continuously absorbing the high forex inflows, the share of net foreign assets in reserve money has increased from 7.8 per cent in 1990 to 119 per cent as in January 2004.

The central bank in its report pointed out that the absorption of these inflows has expansionary impact on money supply with implications for price as well as financial stability, thereby necessitating sterilisation.

The RBI pointed out that apart from exchange rate flexibility and forex market intervention, there are several other policy measures that can be used to manage large capital inflows including trade liberalisation, investment promotion, liberalisation of capital account, prepayment and moderation in the access of corporates to additional external debt, management of foreign direct investment and porfolio investment among others.

Unsterilised intervention in forex markets could lead to an alignment of domestic interest rates with international interest rates, which could have beneficial effects on investment and growth.

At the same time, the central bank also added that forex market intervention accompanied by sterilisation allows the monetary authority to build up international reserves that could help to withstand future shocks.

However, it also cautioned that prolonged sterilisation could exert an upward pressure on interest rates, which in turn could attract further forex inflows thereby neutralising the impact of sterilisation.

It might be added that to date the sterilisation undertaken has not resulted in hardening of interest rates.

"Sterilisation is a means of buying time since only durable and consistent policies enhance a country's capacity to absorb capital inflows," it stated.