The G-20 worked better in the heat of the global financial crisis. Increasing global fragility may make for a productive November meeting.
DESIGNING BARGAINING RESISTANT REGULATION
Delay and discretion are major weaknesses in proposed regulatory reform. 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 rise, and ambiguity in definitions makes arbitrage possible. Since one country or bank may gain at the expense of another no one will alone forsake risky strategies. We argue with taxes and other market regulations as complements buffers can safely reduce, making for a more effective yet feasible combination.
Loss-absorbing capital buffers are an accountant’s approach to reforms. Rather preventive policies should make agents internalize the spillovers they create for others and for the system. But macroprudential policies have largely been left to councils of regulators subject to both discretion and delay. Transaction-based taxes could constrain short-term leverage for all investors taking a position in risky assets, thus also preventing 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; taxes are automatically countercyclical since collections rise with the volume of activity; compared to regulation taxes are non-discretionary, non-discriminatory and based on hard information; risk-based taxes reduce micro incentives to undertake risky activities; unlike capital controls activities remain possible only costs rise.
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—some reversal is compatible with effective functioning of markets. Since OTC derivatives are also to be cleared on central counterparties, all transactions can be taxed.
COMMODITY PRICE SHOCKS
Quantitative easing and low interest rates in the West did not revive real activity but commodity prices rose. Resulting inflation in emerging markets is forcing them to reduce demand. But the latter is especially valuable as the global economy slows. If better commodity market regulations prevent price spikes, emerging markets can continue contributing to global demand.
Consumption growth in Asia has created a scarcity-hype, but total consumption is actually lower since the advanced economies, which are still the largest consumers, are facing 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 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 etc diversified into exchange-traded funds (ETFs) tracking commodity indexes, after the 2002 dot com 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, after netting across all their clients. 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.
REGIONAL REGULATORY INDULGENCE
Large frequent global price spikes associated with the global financial crisis, the S&P US downgrade, and Euro 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 to the West. Volatility increases margin calls. Even if price rise benefits long positions, the subsequent crash hurts them. ETFs make large scale exit also easy. Steep price decreases have begun in gold and silver, as volatility prompts a shift to US dollars and throws doubt on the resource scarcity argument.
The G-20 must help set in good systems. Only a global body can push through a universal tax or position limit. Government allocation makes worse mistakes so markets are necessary. But unregulated and poorly designed markets build up unsustainable excesses.
(The author is professor of Economics. IGIDR, Mumbai. [email protected])
