Ashima Goyal

For a tax on capital market

ASHIMA GOYAL | Updated on November 17, 2011

If position limits reduce the impact of large trades and transaction taxes lower price volatility, participants stand to gain.

A universal tax is a better bet to regulate financial excesses than merely ramping up capital of banks. The November G-20 meet must focus on the former.

The proposed reforms in the financial sector do not seem to be happening in a hurry. There are problems on at least two levels: the current regulatory system and the nature of reforms being pursued. The present approach to reform is marked by delays and the pursuit of a discretionary approach.

Hence, additional capital buffers under BASEL III are not to be put in place until 2018. Western banks with the largest cross-border lending and vulnerabilities are lobbying to dilute even these proposals.

They argue lending rates will go up as costs of compliance rise, and ambiguity in definitions would make arbitrage possible. Since one country or bank may gain at the expense of another, no one will alone forsake risky strategies.

If taxes and other market regulations were to complement capital buffers, it would make for an effective and feasible combination. Loss-absorbing capital buffers are, in fact, an accountant's approach to reforms. They would not address systemic concerns the way, say, a tax on capital market transactions can.

Preventive policies should make agents internalise the spillovers they create for others and for the system. But macro-prudential policies have largely been left to an ineffective regulatory apparatus, leading to both discretionary lapses and delays. The onus is on G-20 to put the right systems in place, when it meets in November.

TAXES vs CAPITALISATION

Transaction-based taxes could constrain short-term leverage for all investors, taking a position in risky assets. This could prevent the arbitrage that creates shadow banks. Their simplicity makes universal application possible.

Since upfront costs are lower for taxes compared to capital charges, banks can lend more in bad times; compared with regulation, taxes are non-discretionary and non-discriminatory; risk-based taxes also reduce micro incentives to undertake risky activities.

It is easy to impose taxes in modern exchanges. But taxes should bear some relation to the riskiness of activities and to the transaction costs charged by exchanges. It follows such taxes should fall in emerging markets, where they tend to be high, and rise in advanced countries, where they are absent.

Since many of these intra-institutional transactions consist of day trades, the tax would not be passed on to consumers. Technology has steeply reduced transaction costs. Since OTC derivatives are also to be cleared on central counterparties, all transactions can be taxed.

MARKET QUIRKS

Quantitative easing and low interest rates in the West did not revive real activity, instead commodity prices rose. The resulting inflation in emerging markets is forcing them to reduce demand. But demand becomes particularly valuable in a situation where the global economy is slowing down. Therefore, if better commodity market regulations can prevent price spikes, the emerging markets can continue contributing to global demand.

While the growth of consumption in Asia has created a scarcity hype, it is forgotten that global consumption is down, since the advanced economies, which are still the largest consumers, are faced with a slowdown.

Since commodities have become an asset class, the structure of financial markets, liquidity, news and expectations of fundamentals all affect commodity prices. As long as informed traders dominate in commodity trading, values should not deviate far from fundamentals, and price discovery through futures markets should help producers plan output and hedge risks.

But there can be one-way movement in futures prices, if everyone expects prices to rise, or if large one-way positions are built-up. There was large-scale index-based investment as pension funds diversified into exchange-traded funds (ETFs) tracking commodity indexes, after the 2002 dotcom crash. Investors tend to take long positions that are continuously rolled over, through OTC dealers, who then buy futures to hedge their own short exposures.

These hedging activities gave ‘swap dealers' exemptions from speculative position limits in the US. But investors are not commercial hedgers. They speculate on future prices, tending to push them up. Swap dealers hedge financial, not commercial positions. The UK is worse, with no position limits. Emerging markets impose such limits.

REGULATORY FLAWS

Large frequent global price spikes associated with the global financial crisis, the S&P US downgrade, and the Europe debt crisis point to regulatory flaws. Even oil producers consider oil futures to be too volatile and prefer to work with an expected price band of $60-80.

If position limits reduce the impact of large trades, and together with transaction taxes lower price volatility, it will benefit participants themselves. Emerging markets, such as Brazil, have done well with tight regulations and a smaller share of OTC transactions, compared with the West.

Volatility increases margin calls. Even if the price rise benefits long positions, the subsequent crash hurts them. ETFs make large-scale exit easy as well. Steep price decreases have begun in gold and silver, as volatility prompts a shift to US dollars.

To reiterate, the G-20 must help set in good systems. Only a global body can push through a universal tax or position limit. Markets are necessary because they allocate resources more efficiently than governments, but unregulated and poorly designed markets build up unsustainable excesses.

(The author is Professor, Indira Gandhi Institute of Development Research, Mumbai.)

Published on October 12, 2011

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