5:28 AM Sep 19, 1994

FREEING ALL CAPITAL MOVEMENTS NOT SO GOOD AN IDEA

Geneva 15 (Chakravarthi Raghavan) -- Freeing all capital movements, and amending or inserting provisions in IMF articles to make full capital account convertibility an obligation or target for Third World countries -- one of the ideas being promoted by the IMF Managing Director -- may not be such a good idea at all, the UN Conference on Trade and Development suggests.

"Capital convertibility," says Carlos Fortin, Officer-in-charge of UNCTAD in his overview of the TDR-94, "must not be turned into an objective of policy in its own right; it is a policy tool, and one among many, to be used when it serves development objectives, and avoided when it does not.

"Under the current global regime for international capital movements," he adds, "developing countries retain considerable flexibility in their policies (unlike developed countries, which are subject to commitments under agreements in the OECD and European Union). Recent experience serves to emphasize the importance of maintaining this flexibility".

The caution from UNCTAD secretariat on capital convertibility found some support from central bank officials of the developing world. At the April G-24 sponsored conference (Cartagena, Colombia, on the occasion of the 50th anniversary of the Bretton Woods institutions) on international monetary issues, Azizali Mohammad (a former IMF official, now Special advisor to State Bank of Pakistan) focused on the durability of short-term capital flows to the developing countries whose sudden falling-off could precipitate bop problems.

At the same meeting, Shaheen Abrahamian, Officer-in-charge of UNCTAD's Global Interdependence Division found much merit in Azizali Mohammad's call for steps to minimise "the more awkward consequences of capital account openness" and then went on press the point "why should we take it for granted that capital account convertibility is the right goal?". While there were advantages in proposals for the IMF to open facilities to offset capital outflows, "this would encourage countries to open up too much, instead of taking steps to keep out undesirable types of flows, steps that could include not only traditional controls but also 'market-based' measures," Abrahamian suggested.

The IMF's Art VIII obliges countries not to impose restrictions on payments and transfers for current international transactions without the IMF's approval. Art XIV has transitional provisions for countries not yet ready to accept Art. VIII obligations -- they can't increase restrictions beyond what they had when they joined the IMF. The IMF regime thus permits controls over capital movements, and in many developing countries such controls are the norm, though half the membership of IMF has not even accepted obligation for convertibility on current transactions.

The industrialized countries have undertaken obligations, through agreements in the OECD and the European Union, to do away with restrictions on capital account too. IMF Managing Director Michael Camadessus in projecting IMF objectives over the next 50 years has advocated moving towards full capital account convertibility as an IMF obligation for all members.

In arguing against this, in its Trade and Development Report 1994 (TDR-94), the secretariat notes that the recent trends towards liberalisation of international capital movements in most parts of the world economy has been accompanied by a growing agreement about potential benefits of long-term international investments, so long as it is subject to some restrictions and conditions.

But there is no such consensus on the benefits of short-term capital movements, even though these too are increasingly covered by liberalization measures -- and could be reinforced by any agreements that might be reached on financial services in the Uruguay Round (which continue for six months after entry into force of the WTO) or the extension of NAFTA to other Latin American countries.

This is because, unless offsetting actions are taken, many of the transactions underlying short-term capital movements are volatile and get easily translated into volatility of exchange rates, asset prices, interest rates, foreign exchange reserves, and supply of domestic finance. They exert powerful influence on the real economy, including resource allocation, consumption and investment.

They shorten time horizons for investment decisions, raise transaction costs, increase incentives of firms to maintain higher markups and greater financial reserves. They blur the signals that exchange rate should give for resource allocation, increase the preferences of wealth holders for liquid as opposed to long-term financial instruments, and thus exert upward pressure on long-term interest rates.

The volatility of exchange rates and foreign exchange reserves exert a deflationary impact on the world economy, due to asymmetric pressures on weaker currencies. While at micro-level unfavourable effects can be countered by purchasing forward, futures, option and swap contracts, they still leave several risks uncovered and can be expensive for developing countries. Increased buying and selling of such options also open up new opportunities for speculation, adding to volatility against which they give protection.

There has thus been increasing attention paid, not only in developing countries and in economic literature, but among policy-makers in the industrial world too, on measures to curb speculative international capital movements.

But since the OECD countries, in addition to the IMF obligations, have also become parties to the OECD code on liberalisation of capital movements, are against direct controls of capital movement as a solution to the problems of speculative capital movements.

This has shifted attention to other methods to restrain them.

While the IMF and OECD approach is to have convergence of macro-economic policies and economic performance -- through targets for price stabiility and fiscal deficits -- the TDR notes that the recent experience of the EU countries leads to scepticism on the likelihood of success on such reliance.

UNCTAD advocates a two-pronged approach.

On the one hand, there should be macro-economic policies to achieve better management of global inter-dependence, including a commitment by governments to defend a publicly announced pattern of exchange rates compatible with high levels of activity and employment.

On the other, there should be reinforcement of effects of such policies by microeconomic measures such as taxation on foreign exchange transactions. This, even if not combined with the first, would still restrain speculation, says UNCTAD.

The levy of a tax on foreign exchange transactions was originally proposed in 1978 by John Tobin. Interest in the Tobin proposal was revived by the 1992-1993 currency instability experiences of European countries and more recently in terms of its potential as a source of revenue for international financing needs.

According to the GATT secretariat's estimates, the world trade in goods and services in 1992 was a $4,640 billion. But the daily turnover on the world's foreign exchange markets was estimated $880 billion per business day in April 1992 or more than $200,000 billion on an annualized basis.

Even a 0.5 to 1.0 percent tax on this turn over would raise substantial amounts, but much less if it accomplishes successfully the task of curbing speculation. It would also be much less if there were to be many exemptions (that would be required so as not to affect the real economy unduly).

Implementation of such a transaction tax, the TDR brings out, would need solutions of several problems on coverage and design.

Such a tax would require agreement to impose it among all countries with significant financial centres since otherwise the business would be transferred to centres where they don't apply. It has to cover both OECD countries and other offshore financial centres, including any new centres that might emerge in developing countries.

Such a transaction tax would need to apply not only to spot and forward transactions and foreign-exchange swaps combining the two, but also to other contracts involving the obligation or right to exchange foreign currencies at a future date through futures and options.

But since positions on foreign exchange can be taken via other financial instruments, when a tax on foreign exchange transactions is imposed, and new instruments would be likely to be devised or existing ones adjusted to evade any such tax on foreign exchange transactions, and no tax could be designed to safeguard against all such eventualities, the need for alteration in the tax's design to tackle new or adjusted instruments are called for.

Any such tax, once the type of transactions to be covered are decided, would still need solutions to problems related to modalities of the tax, such as valuation of different transactions for tax purposes and the timing of tax payments.

Another fundamental question, the TDR notes, would be which economic agents are to be subject to this tax. Applying it to banks as well as non-financial actors would not only "throw sand into the wheels" of speculation, but raise costs to banks for providing services for non-financial, non-speculative business of international trade and investment. But this cannot be a decisive argument against application of a transaction tax to banks nor is there any a priori reason why any economic activity should be exempt from taxation under all circumstances, particularly since tariff-cutting exercises have reduced costs of international trade, the TDR notes.

While non-banks have been a major source of speculative pressures in currency markets, banks too assume open positions in these markets and their foreign exchange trading have been an important source of profits.

However, the TDR suggests, there are other ways of reducing foreign exchange speculation by banks, and less open to objections of raising transaction costs for non-financial activities.

Banks could be required to make non-interest-bearing deposits corresponding to increases in open positions in foreign exchange. Since this would apply to balance-sheet positions, it could serve as a tax on speculation without raising costs of banks in providing a foreign-exchange service for international trade and long-term investments.

A capital charge could be imposed on banks' open positions in foreign exchange though, this too as the transaction tax, would need international agreement for adoption by all countries with significant banking centres. This approach could rely on regulations analogous to the Basle Committee initiatives on Banking Supervision for standards for supervision of banks' market risks including those due to their positions on foreign exchange. While this initiative is narrowly directed at objectives of prudential supervision of banks, TDR says it would also cover the very transactions through which banks engage in speculation.

But even this capital requirements approach would leave leeway for speculation by banks, as these would apply only at close of each banking day (and which was exploited in the 70s by Citibank in Europe when it indulged in overnight 'parking' of positions, taking advantage of the closing and opening of markets in various centres in various time-zones). To deal with this, in practice banks would need to be asked to maintain levels of capital against their open foreign-exchange positions significantly sin excess of prescribed minima -- an attempt that would complicate the Basle Committee's initiative.

UNCTAD suggests in this regard that it might be preferable to wait until there is experience in practice of the effects of the Basle Committee initiative and then, if additional restraints on foreign exchange speculation is deemed necessary, to impose continuously applied capital requirements.

But given the time-horizons for these and the recent, mostly short-term, capital inflows into the developing countries with their negative effects, the UNCTAD advices developing countries to maintain flexibility to regulate capital transfers.