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Curbing forex speculation
December, 22nd 2006

Currency control measures announced by Thailands Central Bank on Monday (some of which were rolled back the following day) including a 10% tax on short-term withdrawal on investment created a havoc in markets across the region. These measures are a variation of a tax on all cross-border currency transactions, first mooted by economist James Tobin in the early 70s.

What is Tobin Tax and how did it come about?

Till 1971, the US dollar was pegged to the gold standard, which in effect meant that the amount of dollars the Federal Reserve could print was restricted to its underlying gold holdings. In 1971, the US government decided to take the dollar off the gold standard, which theoretically gave it the right to print any amount of dollars it chose to.

As a result, liquidity in the system shot up, encouraging currency speculators across the globe to bet on or against the dollar. To deter excessive currency speculation, Nobel Laureate economist James Tobin proposed a small tax on international currency transactions in 1972. The proposed tax rate was to be between 0.1% and 0.25% of the value of transaction.

What are the pros and cons of Tobin Tax?

Proponents of the tax says it will discourage short-term currency trades, which if not controlled, can result in economic crises through a collapse of the domestic currency. Currency speculators buy and sell currencies quickly to take advantage of very small price differentials. Even though these price margins are very small, they are still large enough for speculators to make substantial profits as they trade in thousands or millions of dollars worth of currency contracts or bonds at a time.

The small tax would shrink the already narrow margins, making these quick trades unprofitable. Those who oppose this, however, argue that a tax will only increase the transaction cost and hurt economic growth without any long-term influence on volume of transactions.

Why did Thailand propose capital control measures?

Thailand says it is a victim of too-much of capital in-flow, resulting in sharp increase in currency. Thai bhat hit a nine-year high against dollar on Monday, topping off a 16% rise this year. This has eroded Thais export competitiveness threatening an economic downturn. Foreign investors have poured in around $2.8 billion into Thailands stock exchanges since the beginning of this year. 
 
How other countries have responded to the concept of Tobin Tax?

Though Tobin Tax has not found an universal appeal, quite a few countries have adopted its variations in times of economic crisis. Most celebrated is measures announced by Malaysian government in response to the 1998 South East Asian crisis. It involved fixing the local currency to the US dollar, stopping the overseas trade in ringgit currency and other ringgit assets, restricting the amount of currency and investments that residents can take abroad, and requiring a minimum one-year stay period for foreign portfolio funds.

The last measure has since been converted to an exit tax. Though the controls sparked an enormous controversy in the world of international finance, it insulated the Malaysian economy from the unstable international financial system. Malaysia was the first country to recover from the crisis.

Who are the major supporters of the concept?

In June 2004, Belgian Federal Parliament approved a bill implementing the Spahn tax (a version of the Tobin Tax proposed by Paul-Bernd Spahn). According to the legislation, Belgium will introduce the Tobin Tax once all countries of the eurozone introduce a similar law. Earlier in March 1999, the Canadian House of Commons passed a resolution asking the government to enact a tax on financial transactions in concert with the international community. Tobin Tax has also been supported by Brazilian president Lula da Silva and Venezuelan president Hugo Chavez. Support for the Tobin Tax has also come from the multimillionaire speculator George Soros, who stated that, while the tax goes against his personal interests, he thinks that its introduction could have positive effects on the world economy.

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