Global Policy Forum

By, Matthew Siegel

Introduction

In the aftermath of the economic and political devastation caused by capital flight from Mexico, Russia and the Asian economies, the need for some control over short term and speculative capital is clear. There are a variety of proposals from academics, officials and activists for bringing control. However, which are most likely to further the goals of equitable and sustainable development? And which can garner the political will necessary for implementation? This paper offers a point of departure for discussing these two pressing topics.

Growth of Capital Flows

In 1973, when daily foreign exchange trading around the world varied between $10 and $20 billion per day, Canada, Germany and Switzerland abolished all restrictions on international exchange. The following year, the U.S. abolished all exchange restrictions. By 1980, all of the world's free economies had abolished exchange restrictions except for France and Italy, which followed in 1990.

Foreign Currency Trade - In 1980, the daily average of foreign exchange trading was $80 billion, a 10:1 ratio to world trade. By 1992, daily trading had reached $880 billion with a ratio of 50:1. In 1995, daily trading was $1.26 trillion and the ratio to world trade was 70:1. "By far, the greatest part of currency trades was very short run. Given that the vast majority of trades are not for the finance of trade in goods and services or long term investment, these short-term trades must be based on expectations of gain derived from changes in the value of financial assets. In the broadest sense, they are speculative." (Eatwell 1996, p.4)

Bond Trade - between 1983 and 1993, international sales of US Treasury bonds rose from $30 billion to $500 billion. Sales and purchases of bonds and equities between foreigners and US residents rose from 3% of US GDP in 1970 to 135% in 1993. In the UK over the same period, international securities transactions rose from near zero to over 1000 percent of GDP.

Bank Lending - the stock of international bank lending rose from $265 billion in 1975 to $4.2 trillion in 1994. McKinsey Global Institute estimates that the total stock of all financial assets traded in global markets rose from $5 trillion in 1980 to $35 trillion in 1992, twice the GDP of OECD countries.

This burst in global capital flows followed the collapse of the Bretton Woods system of fixed exchange rates in 1973. "The fluctuating rate system that took its place stimulated capital flows with a powerful cocktail of the carrot of speculative profit and the stick of financial risk, laced with the proceeds of extensive arbitrage." (Eatwell 1996, p.5)

Without fixed exchange rates, currency risk was privatized. That is, private banks and other financial institutions had to take on the risk that the exchange rate of currencies in which they were dealing would fluctuate over the period of the investment. Thus, many new risk-reducing instruments have been developed and capital controls have been weakened to allow for these private instruments.

The last decade has witnessed a particular rise in financial flows to developing countries. Portfolio investment in developing countries rose from $3 billion in 1990 to $40 billion in 1996. The percentage of emerging markets classified by the World Bank as allowing "free entry" to foreign investors rose from 26 percent in 1991 to 58 percent in 1996.

What is the Problem?

We observe economic chaos and anxiety occurring around the globe. We also see widespread social dislocation - loss of jobs, millions of people falling below the poverty line, some into starvation. Alongside the previous growth and current decline is ongoing destruction of the environment - in August 1998, the government of China conceded that widespread deforestation had aggravated the devastating summer floods; in Indonesia forest fires consume precious rainforests producing a region-wide haze for the second year running. What is the connection of all this suffering to the contemporary increase in the movement of international capital?

This paper identifies those aspects of global capital flow that have aggravated the current crisis, explore options for correcting these aspects and begin a discussion for devising political strategies that achieve an international economy that is more equitable, more sustainable and includes more participatory decision-making. So, we begin with the main cause, short-term and speculative capital (hot money), the component of international capital flow that is the most damaging to the real economy and the primary catalyst for the recent and on-going crises.

Short-term capital flows include transactions such as three-month renewable loans and portfolio (stock and bond) investments. These types of investment do not, necessarily, remain in a country for only a brief period; if the three-month loan is renewed consistently over a five-year span or the portfolio remains invested for several years, this capital stays in the country for a lengthy period. For our purposes, the most salient feature of short-term investments is the high degree of liquidity. That is, they are easily and quickly sold or withdrawn. The lender or investor (in the Mexican and Asian crises these were mostly foreign investors such as banks and hedge funds) prefers a high degree of liquidity to compensate for the high risk of investing in developing countries.

Speculative investment refers to money that is invested in highly liquid instruments based on an expectation of the price or currency value to decrease or increase thus creating an opportunity for selling at a profit (known as arbitrage). Most famously, speculation involves attacks on currencies that are expected to devalue. In this case, speculators sell the currency when it is high and buy it back when it fallsii. One problem with this kind of speculation, from the point of view of the target country, is that it tends toward self-fulfillment as behavior based on the expectation of devaluation creates an actual devaluation.

Human misery and environmental degradation occurs when turbulence in the financial world spills over into the real economy (e.g. wages, food prices, interest rates for small businesses). For example, devaluation of the baht in Thailand made it impossible for Thai businesses and banks to make payments on their dollar denominated loans. Both events scared foreign investors who quickly sold or cashed their liquid investments and withdrew their capital from the country. This sudden and massive withdrawal of capital devastated the real estate market in Bangkok, leading to falling land prices. This land had provided collateral for extensive loans in Thailand, which overnight made a majority of loans on Thai banks' books in technical default.

Similarly, in Indonesia, after the rupiah lost 60 percent of its value in 1997, foreign investors refused to roll over (renew) their short-term loans to Indonesian businesses. Because the Indonesians were using the short-term loans, the only kind they could qualify for in the international market, to fund long-term projects, they did not have the cash on hand to repay the principal on the foreign loans. Indonesia immediately defaulted on $60 billion of external debt and the rupiah continued its plunge. Meanwhile, the budding Indonesian middle class, now enduring a severe recession, turned their efforts toward simple survival and 40, by some estimates 100, million people have fallen below the poverty line.

In conclusion, short-term investments that are easily liquidated and speculative capital movements threaten the stability of real economies, especially in the developing world, and force fiscal policy to be focused on keeping the financial markets happy rather than focused on raising standards of living. The policy proposals described below are designed to curtail the destructive nature of this kind of capital movement and to engage capital in the process of building a more equitable, sustainable and participatory economy.

Policy Proposals

For ease of consideration, this paper divides the means of regulating international capital flows into three broad areas: taxes, capital controls and controls on currency exchange. Under each heading, political feasibility, technical feasibility and whether the means achieve the ends are considered.

Political feasibility addresses the ease with which the proposals might be realized through a political process. Technical feasibility refers to the ability of any institution to implement the proposal.

In the final section, the institutional mechanisms for implementing the policy options are described. Here, the division of opinion between those who support national approaches and those who support international approaches is sometimes quite stark. However, it is hoped that the description here illuminates some possibilities for common ground between the two camps.

Means of Regulating International Capital Flows

1.Taxes

Taxes can be imposed at different points in a transaction (when a currency enters/exits a country, when currency is exchanged, when data is transferred, etc.) to make short term and speculative trades prohibitively expensive. Taxes are a form of regulation that is intended to influence the market without disrupting the functioning of the market.

Political Feasibility - Taxes are unpopular. Thus, support for them is difficult to build. When arguing for taxes some activists focus on the positive market effect (correction of market failure) of the tax while others emphasize the uses of tax revenue. The decision of which to emphasize should be based on the political viability. Technical Feasibility - Deciding on the tax rate is largely a mathematical matter. Given the objectives of the tax and the goal of reducing speculative exchange by a certain level, it is a matter of mathematics to devise the appropriate rate. The contentious issues have to do with collection and evasion. For instance, what body should administer a tax on currency and what would prevent capital fleeing to havens where the tax is not applied?

Do the Means Achieve the Ends? - Taxes would almost certainly slow movement of short-term capital and create revenue. Speculative trading, which is mostly trading of currency to take advantage of rate fluctuations and interest rate differentials (arbitrage), is based on very small margins. A tax on each direction of the exchange would effectively negate the potential for short-term profits. However, taxes probably would not prevent the kind of capital flight we have witnessed in Asia, Mexico and Russia because in these cases the cost of the tax would not have outweighed the risk of the investment. Uniformly imposed taxes would eliminate a race to the least-common-denominator among developing countries.

Examples -
Tobin Tax: The Tobin tax is a tax on spot (same day) currency transactions, which collectively amount to about $1.4 trillion per day. The tax would negate the opportunity for arbitrage (make a profit on the rate differential). Because the rate differentials are so small, even a low tax (e.g. 0.25%) would raise the cost of the trade above the expected gain. For long term investments, the tax should not be much of a deterrent because it will be small relative to the potential gains. It would also facilitate information gathering, reinforcing the objective of transparency.

The major argument in opposition is that it would be very difficult to get all countries to agree and then implement the tax. If the tax is not applied uniformly, countries with a lower tax or no tax at all will become havens for capital deposits thereby avoiding the tax. David Felix (prfessor emeritus, Washington University in St. Louis) has countered that agreement by the major currency trading countries (US, UK, Japan, Singapore, Switzerland, Hong Kong and Germany) would be sufficient to achieve the policy objective as these countries account for 80% of international currency transactions. Peter Kenen (professor, Princeton University) adds that charging a punitive tax by non-haven countries on trades with tax havens would deter their use. In other words, non-haven countries can deal with tax havens by legislating away their use.

Tax on Short-Term Profits: To reduce currency speculation - J. Melitz proposes a 100% tax on foreign exchange profits held for less than one year. Warren Buffet has suggested that all gains from sale of stocks or derivative securities held for less than one year face a 100% tax. Such a high tax would make short term trading highly unprofitable. (Singh1998, p.152)

Security Transfer Excise Tax (STET) and Financial Transactions Tax: This would be a national tax on the sale of equity, shares, bonds, options, etc. within each country. Because most trading of foreign exchange is for the purpose of buying or selling one of these assets, the tax would lessen volatility in the foreign exchange market. The FTT is a broader Tobin tax that would apply to more kinds of transactions. This tax would tend to limit trade and insurance financial transactions as well as short-term transactions.

2.Currency Exchange Controls

These are more direct regulations that limit the volume or price at which a currency may be traded.

Political Feasibility - Many countries already use some kind of exchange control so the idea has precedent. For example China and India place restrictions on the trading of their currencies. Under the Bretton Woods system, all the world's currencies were set to the US dollar.

Technical Feasibility - Exchange rate controls are notoriously difficult to maintain. Before 1997, Thailand managed its exchange rate within a range of prices but could not sustain the range under speculative attack. Hong Kong, which uses a currency board to control the exchange rate, has successfully withstood several attacks on its currency. However, Hong Kong has one of the world's largest caches of foreign reserves and is backed by China's immense foreign reserves.

Do the Means Achieve the Ends? - The policy goal is to achieve some level of stability in exchange rates. Exchange rates are affected by various factors in the real and financial economy such as interest rates, inflation, growth rates and monetary and fiscal policy. Among economists, the debate rages as to whether fixed or floating or something in between is the optimal policy. The operative progressive question for any country is what policy will offer the greatest stability in the most equitable and sustainable fashion (i.e. least cost).

Specifically, the progressive community should consider the national fiscal and monetary implications of currency controls. For example, governments that opt to defend their currencies must adopt fiscal policies aimed at preventing or mitigating currency collapse, and may not have the resources nor the fiscal flexibility, to address pressing social needs such as poverty, health care and pollution. Currency exchange policies also constrain national monetary policies.

Examples -
Direct Currency Controls: This can be achieved through fixed exchange rates (the government sets the exchange rate of the national currency). This type of control requires extensive administration and generally fosters a black market for the currency.

Managed Exchange Rate: Smaller countries fix the value of national currency to a large country's currency (such as the US dollar) or to a combination of several currencies (e.g. tied to a weighted average of the US dollar, Japanese yen and German mark) at a particular rate.

Global Interest Rate: This would have the effect of stabilizing exchange rates. It would limit the opportunities for the financial industry to profit from fluctuations in exchange and interest rates. The implication of global exchange rates is that the macroeconomic policies of all countries would be closely coordinated (similar to the European Union).

Restrict and License Foreign Exchange Transactions: This would limit currency trading to particular parties and/or volumes thereby limiting volatility of the currency.

3.Control of Capital Inflow and/or Outflow (Speed Bumps)

These controls apply directly to the inflow and outflow of foreign money. A country stipulates specific requirements to which foreign investors and/or nationals must adhere. These requirements can include time restrictions, types of industry and/or local sourcing/employment types of incentives. Control of capital can be implemented at a national level. China and India, both with forms of capital control, have suffered much less financial volatility than their Asian neighbors over the last year.

Political Feasibility - Many countries have these kinds of requirements which suggests that control of short-term flows would represent an expansion of existing regulations. However, international agreements like the MAI would prohibit this type of control.

Technical Feasibility - In theory, guided investment is simple, but in practice it can be very complex. It can be difficult to ensure that the intended beneficiaries of the policy actually benefit while preventing vested interests from taking advantage of favorable terms.

Do the Means Achieve the Ends? - Chilean controls illustrate how these types of policies can effectively dampen the activity of short-term traders without losing the benefits of long-term foreign investment. Achievement lies in the details. In principle, controls seem to achieve the policy goal of slowing speculative and short-term capital movements, a general goal stated to be in the interest of the poor and the environment. Also, some capital controls on short-term investments can complement controls governing longer-term investments (such as a requirement for joint ventures in the technology sector). However, the specific design will determine how much the policy actually benefits these constituencies. For example, poor design can lead to opportunities for graft and evasion that might contribute to greater inequalities.

Examples -
Capital Controls ("Chilean model"): Chile requires foreign investors to place 20 percent of investments into a fund at the central bank that can not be withdrawn for twelve months. This requirement was increased to 30 percent in 1992 but was recently lowered to zero following the extended crises in developing countries. Chilean requirements create an incentive for foreign investment to be long-term by raising the cost of short-term investments. The requirements do not eliminate short-term investments, they just make them unprofitable. This approach has been successful in limiting short-term flows. In 1992, investment by arbitrage funds in Chile equaled 3.5 percent of GDP compared to almost zero in 1994. Standard and Poors, a New York-based rating agency, gave Chilean bonds a very strong ranking in 1995.

Regulations on International Transfers (similar to current Malaysian policy): National regulations require government approval for any inflow or outflow above a certain level of either foreign or domestic currency. For example, in South Korea before 1994, government approval was needed before loans of a certain size were made from overseas. This limited the amount of Korea's foreign debt. Because this approach limits the volume of international currency exchange it also limits volatility in the exchange rate.

Directed Investment (Control of Capital by National Government): Foreign capital can be allowed selectively into certain sectors such as industries targeted for growth or agriculture and restricted from other sectors such as the stock market and real estate. Another version of this, proposed by Jane D'Arista of Boston University, would turn the short-term debt of developing countries into a long-term closed fund (no new shares sold) issued by the World Bank. This debt could be freely traded. Because the fund is closed and the debt long-term, repayments and the status of the debt would remain stable for the developing country borrowers. These kinds of regulations allow for stability in pursuing development objectives but can be subject to domestic political abuse. The danger is that foreign money will be channeled into those sectors with the most political clout rather than those with the most potential to benefit the economy equitably.

No Foreign Investment: Foreign investment can be prohibited completely. This protects the economy from shocks in the global financial system and should significantly reduce exchange rate volatility as the volume of exchange would be limited to that necessary for trade.

Restriction of Hedge Funds (margin controls): Hedge Funds borrow enormous sums of money to make bets on currency fluctuations. These funds are typically able to borrow as much as 20 times their collateral and are a significant source of currency instability. A restriction on the multiples hedge funds may borrow might limit the effect of the funds on the currency market.

Institutional Mechanisms

Once a particular tool (or tools) for capital control has been chosen, it will need to be implemented by an institution - most likely a governmental institution. The type of control determines in part which institution is best suited for implementing it. In general, institutions that enforce capital controls are either national or international. Some controls, by their nature, can not be implemented by a national institution and, vice-versa, some can not be implemented by international bodies. The following section addresses various forms an international organization that regulates capital might take. National institutions are not specifically described in this section because conditions in each country vary.

International Institutions

International institutions should complement and reinforce national controls, addressing the aspect of cross-border capital flow that lends itself to international regulation. They should not constrain national efforts to regulate capital.

Political Feasibility - New international institutions would require significant international consensus and political momentum. Modifying the mandate of existing institutions may demand less political will.

Technical Feasibility - This level of enforcement on an international level is uncharted territory. The World Trade Organization offers some insight into how such a body, from a political and administrative perspective, might operate. The UN is another example.

Do the Means Achieve the Ends? - This would vary depending on the institution created. In general, international institutions are plagued by a lack of accountability and transparency relative to national institutions. This implies that global institutions begin with a sort of demerit by virtue of their supranational character. It should be shown that the benefit of the policy tool implemented by the global institution outweighs this fault.

Examples -

National governments

Bank of International Settlements (BIS): Created at the Hague Conference (1930), the BIS is the international central bank of national central banks. It acts as a lender of last resort for these central banks and its capital is comprised of deposits by these banks plus some private international financial institutions. The BIS monitors the Basle Accord of 1988 that established an international minimum capital requirement (8%) for banks (i.e. percentage of the total assets of a bank that must be owned by the bank).

World Financial Authority (WFA): This organization, proposed by John Eatwell, a professor at Cambridge University and an advisor to the Labor government, and Lance Taylor, economist at the New School, would grow out of the Bank for International Settlements. The WFA, a kind of international financial regulator, would have the both the regulatory power and resources of a national central bank. Eatwell and Taylor argue that part of the reason for the failure of the IMF to operate effectively as a lender of last resort is that it lacks the necessary authority and resources. For instance, during the savings and loan crisis in the United States, the federal reserve had the authority to shut down troubled institutions, selling them to other banks, liquidating assets and firing boards of directors. It also had the resources to infuse money into the banking system to prevent a collapse of credit. The IMF, with its current powers, lacks both of these levers.

International Monetary Fund (IMF): The IMF, created at the Bretton Woods conference (1944), is mandated to assist countries experiencing imbalances in their balance of payments. This usually means that a country is having trouble meeting its foreign debt or trade payment obligations. In this circumstance, the IMF steps in with loans to help that country meet its obligations.

New UN/ International Conference on Money and Finance: At the original Bretton Woods Keynes argued that countries must have enough control over global capital to pursue policies of full employment and social justice. His original outline included :1) "Clearing Union" to help with balance of payments; 2) international currency; 3) international trade organization to stabilize commodity prices; 4) aid program with low cost loans and grants to developing countries. (Dillon 1997, p.94)

World Central Bank: An institution with a broader mandate than the BIS or WFA. It might be authorized to enforce reserve requirements for all international financial institutions, including mutual funds and hedge funds. It might also be empowered to establish interest rates and or exchange rates.

Conclusion

There is no one "silver bullet" that will reduce the volatility associated with short-term and speculative capital. These policy proposals are not mutually exclusive; in fact, some of the proposals may be complementary. This paper has provided a point of departure for discussing what kind of financial regulation will best foster the financial stability that allows countries to build the social, economic, and political policies which promote democracy, public participation, equity, and sustainable development. Although social ills and environmental degradation on the "ground"are several steps removed from volatility in financial markets, the link is real and powerful. The challenge for participants in this working group is to identify those regulations of speculative and short-term capital that best complement the economic, environmental, and social policies that promote sustainable development in the real economy.

Selected Bibliography

Dillon, John (1997) Turning the Tide: Confronting the Money Traders, Canada: Ecumenical Coalition for Economic Justice and Candian Centre for Policy Alternatives.

Eatwell, John (1996) International Financial Liberalization: The Impact on World Development, New York: United Nations Development Programme, Office of Development Studies, Discussion Papers Series, 12.

Singh, Kavaljit (1998) A Citizen's Guide to the Globalization of Finance, Delhi: Madhyam Books.

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