The Hindu Business Line : Managing capital inflows the Chilean way

Imposing some kind of ‘entry tax’ on foreign inflows will help control their volumes, and guard against such consequences as a spurt in the rupee leading to problems for our exporters, increasing cost of sterilisation and rising domestic interest rates.

Bharat Jhunjhunwala

Large inflows of capital are basically good news for us. But good things, like butter, can also be harmful if taken in excess. Our strength, therefore, lies in allowing in only so much foreign capital that is beneficial for us. The Finance Minister, Mr P. Chidambaram, has indicated that the Government is thinking of imposing a tax in some form to regulate these inflows. This move must be welcomed.

The idea of taxing capital movements was first mooted by Nobel Laureate Professor James Tobin in the 1970s. He suggested that cross-country capital movements could be taxed by the IMF or the World Bank and the revenues used for poverty alleviation in the developing countries.

This could not be implemented because of a lack of consensus, especially on how to share the revenues and which transactions must be exempted. But countries such as the United States, Israel and Chile have imposed unilateral taxes on capital flows at various times. The experience of Chile is particularly relevant for India at the present juncture.

Chilean approach

Chile was facing large capital inflows in the early 1990s, much like are facing today.

The Chilean peso was rising. A report by Third World Network, titled “Regulation of foreign capital flows in Chile” explains: “In June 1991, the authorities imposed a stamp tax on external loans at an annual rate of 1.2 per cent on operations of up to one year.

Also, external credits were subjected to a non-interest-bearing reserve requirement of 20 per cent.

The reserves had to be maintained with the central bank for a minimum of 90 days and a maximum of one year. This deposit had the same effect as a tax. The result appears to have been good.”

A study by Sebastian Edwards of University of California, Los Angeles, on the Chilean experience reports that immediately after the implementation of the policy, flows with less than a year’s maturity declined steeply relative to longer-term capital.

However, with the exception of a brief decline in 1993, the total volume of capital inflows into the country continued to increase until 1998. Chile’s short-term debt as a proportion of total debt declined from 19 per cent in 1990 to less than 5 per cent in 1997. The policy also helped reduce stock market instability.

The message for India is loud and clear. Imposing some type of ‘entry tax’ on foreign investors will help reduce capital inflows. This will save us from various unwanted consequences, such as spurt in the rupee leading to problems for our exporters, increasing cost of sterilisation, rising of domestic interest rates, etc. The Finance Minister would do well to impose such a tax immediately.

Control on inflows

The University of California study has criticised this policy saying it was not able to isolate Chile from the financial shocks stemming from East Asia in 1997-1999. It also led to an increase in the cost of capital. The controls on inflows also failed to stem the appreciation of the peso. The real exchange rate appreciated by approximately 30 per cent during the 1990s.

The Chilean policy cannot be discredited on this ground. Its effectiveness has to be assessed by looking at the scenario that would have prevailed in absence of imposition of the tax. This policy is not a panacea for all evils. Its positive impact on restraining capital inflows is unquestioned. Maybe a higher level of tax or some other stratagem would have succeeded better. We should, therefore, build upon it rather than discredit it.

The idea of taxing capital inflows has been, predictably, criticised by the International Monetary Fund Chief, Mr Dominique Strauss-Kahn who, according to one report, “cautioned India that curbing capital flows too much could undermine confidence in the country. It was important to enhance the transparency of capital flowing into the country but limiting it may not always be good,” he said.

Global investors, of course, would not like such a tax to be imposed.

The IMF is peddling their interests and ignoring the possible adverse impact of large flows on India. It escapes the IMF’s attention that imposing a tax on inflows can enhance confidence in the Indian economy.

A high-priced item is assumed by consumers to be of better quality. Likewise, taxes on inflows may enhance, not reduce, confidence in Indian financial products.

Impact of taxation

The University of California study noted that capital inflows continued to Chile despite imposition of such tax. So also is it likely to happen for India.

Another objection to such tax stems from the inefficiency inherent in any such policy. Imposition of tax raises the price of capital to above the prevailing market rates.

Say, the rate of profit in Chilean economy was 20 per cent and it attracted capital inflows of $10 million. Imposition of a tax on capital inflows would reduce the effective rate of profit for foreign investors to, say, 18 per cent and, accordingly, lead to reduction of inflows to, say, $8 million.

The Chilean economy and world economy would thus be deprived of the profits from additional flow of $2 million that could have been obtained.

The problem with this argument is that losses to the Chilean economy from excessive capital inflows are not accounted for. Chile may stand to benefit from such tax despite the higher cost of capital because of those savings.

Such a tax does become a loss proposition for the global investors, however.

Thus institutions such as the IMF must be seen to promote the interests of global capital against the interest of recipient countries. Mr Chidambaram would do well to ignore contrary advice and impose a tax on capital inflows forthwith.

(The author, a freelance writer, can be contacted at bharatj@sancharnet.in)