Taxing Excessive Currency Speculation To Prevent Social Crisis and Finance Global Challenges A CIDSE-Caritas Internationalis-Justice and Peace Europe Background Paper - January 1999 Part One

Taxing Excessive Currency Speculation
To Prevent Social Crisis and Finance Global Challenges
A CIDSE-Caritas Internationalis-Justice and Peace Europe
Background Paper - January 1999

Part One

THE BIRDS: THE DRAMATIC SOCIO-ECONOMIC EFFECTS OF EXCESSIVE SPECULATION AND THE LACK OF AVAILABLE FINANCE TO CURE AND HEDGE THEM

1. The dramatic effects of excessive currency speculation

In order to value transactions with the outside world, the value of a country's currency is related to the value of the currencies of other countries by means of an exchange rate, according to a specific mechanism. The different types of exchange rate mechanisms can be reduced to two basic types: fixed or floating.

In a floating exchange rate system, the value of the country's currency vis-à-vis other currencies is allowed to change (more or less) freely, according to supply and demand for the currency which is, in essence, determined by changes in the so-called underlying 'fundamentals' of its value, such as the policies and macroeconomic performance of the country.

Because of the presumed scope of exchange rate volatility in a floating exchange rate system, a large number of countries engage in some sort of fixing of the exchange rate, be it in a regional context, such as the European Monetary System, where exchange rates can only change within a certain narrow margin (to end up in a uniform single currency system by 1999), or unilaterally, where the country's currency is somehow linked in a fixed relation ('parity') to the value of an anchor currency such as the dollar. In a fixed system, the value of the currency is stable until a certain parity can no longer be held, and then, moves to a different parity currency (by a 'devaluation' or 'revaluation'), or starts floating. A forced downward change in parity is usually the result of a consensus among market participants in the international financial market that the current parity can not be held, and as a result, that supply of the currency (e.g. by sell orders) becomes much greater than the demand for it. It is usually triggered by massive speculation that this indeed will happen.

With currency trading, the daily volume of operations dwarfs any other financial market. In a detailed market survey conducted by the Bank of International Settlements (BIS) in 1995, the global daily volume of currency transactions was estimated at about US$ 1.3 trillion (see appendix one for an explanatory overview of different types of currency transactions). Today, global currency market turnover is nearly US$ 1.5 trillion. An estimated 80-90% of the transactions have no direct link with the necessities of the end-user demanding foreign exchange for international trade or payment purposes.

With respect to the time period of the transactions, the BIS statistics show that about 80% of all transactions involve round-trips (i.e. a purchase operation followed by a resale operation) within 7 days or less, and more than 40% within 2 days or less. This indicates that the majority of currency trading is short-term. Large institutional investors and financial institutions routinely engage in short-term arbitrage transactions, trading away price differences for the same currency in different markets. These operations are non-speculative by nature, but are important for the efficient fixing of prices in financial markets, and for the securing of world-wide liquidity.

What is currency speculation?

In general, speculation deals with the deliberate taking of an additional risk (create an 'open position') by buying or selling an asset in order to take advantage of an anticipated favourable future price change of the underlying asset. The main determinant here is the subjective interpretation of future price changes, or the possession of superior information, so the speculator believes he can 'beat the market'. With respect to currencies, it refers to the buying and selling of currency (be it spot, or through some derivative financial transaction (see appendix 1)), or the borrowing and investing in a specific currency, without having an 'underlying' position in the currency (by possessing the currency now or having a future contractual income or outflow position in it) (1).

In principle, large-scale speculation is triggered because the underlying 'fundamental' economic and political indicators worsen or necessary reforms are not carried out. Under a fixed exchange rate system, usually the central bank of a country tries to defend the current parity by selling its foreign exchange reserves for local currency and thereby matching the increased supply of local currency by increased demand, or by increasing domestic interest rates that increase the attractiveness of holding local currency. Such a stand-alone defence of a central bank cannot succeed for very long against the market. Alternatively, a country could try to (re)install controls on international transactions to make a currency attack more difficult; this might be more effective.

Indeed, from an ethical viewpoint, it can be argued that intervention in currency markets should not be promoted when it goes against a 'fundamental' trend and is only used to enable countries to continue to pursue unsound economic policies, e.g. the kind of 'crony capitalism' pursued by some countries. However, intervention is justified because of the following phenomena existing in currency operations:

The existence of destabilising trading, i.e. so-called 'noise trading' (as opposed to trading on fundamentals). Noise-traders act on price dynamics only, driven by misinformation such as technical analysis or 'rumours'; behaviour that may drive prices away from their fundamental value. Band-wagon or herding effects, where everyone starts to mimic the action of a few leaders may, in principle, worsen the case. One of the more mythical players in this respect are the so-called 'hedge funds', that are sometimes held responsible for triggering a crisis because of the sheer volume of their operations and the demonstration effect they have on other investors, turning a currency crisis into a self-fulfilling prophecy. This also raises the issue of market manipulation by powerful agents.

Theories on speculative runs clearly show that speculative attacks take off too early, before a clear (current) fundamental worsening of the value of the currency is witnessed. It is driven by expectations, and it starts as soon as speculators think the attack has some chance of succeeding (2). As such, countries may not be given time enough to change their policies for the better. The purpose of effective intervention should be to give them time to readjust.

These speculative transactions are not just (private) 'zero-sum games', where one party gains what the counterparty in the transaction loses. Because of their potential to trigger a financial crisis, these 'games' can have large social costs:

on the countries involved, especially on their most vulnerable groups. Box 1 highlights the social impact of the current crisis in Asia

by 'contagion' on other countries that are not directly involved and which provokes a global chain reaction of financial 'panics and crashes' (the so-called 'systemic risk'). In the 1995 peso crisis, strong effects were transmitted to countries such as Argentina. The Asian currency crisis had direct contagion effects on countries such as the Philippines and Singapore, and ultimately, because of the real economic linkages, to the whole world. The direct costs are huge: the Asian currency crisis has lowered current world growth projection for 1998 alone by about 1%; since world GDP is about US$ 30,000 billion, total costs can be estimated at US$ 300 billion at least. World-wide, the ILO (International Labour Organisation), in its 1998 World Employment Report, estimated that unemployment increased by 10 million people solely due to the Asian financial crisis.

BOX 1: The social impact of the East-Asian currency crisis

An early assessment of the social impact of the East-Asian currency crisis in three countries: Indonesia, the Republic of Korea, and Thailand.

Unemployment: open unemployment has increased significantly relative to the pre-crisis year 1996. In Indonesia, the projected official unemployment rate will increase from about 4% in 1996 to between 9 and 12% at the end of 1998. In the Republic of Korea, it grew from 2% in 1996 to 4.7% in February 1998 and a projected 6.2% at the end of 1998. In Thailand, an increase from 1.5% in 1996 to about 6% at the end of 1998 is projected. Additionally, underemployment, which is much more difficult to measure, is said to be have increased considerably. In the Republic of Korea in particular, it put an end to the psychological myth of secured lifetime employment. More than occasional cases of suicide, due to loss of employment, have been reported. Most of those losing their jobs have little choice but to become active in the informal sector.

real wage levels: the strong increase in real wages of the past few years was abruptly halted in 1997 and turned negative in 1998. As an example, in the Republic of Korea, real wage growth which was on average 6.5% during 1995-96, was reduced to 2.7% during the third quarter of 1997, and -2.3% during the last quarter of 1997. It is particularly the bonus element in wages that accounts for this decline. In Indonesia, it is estimated that real wage levels will decrease by more than 15%

change in poverty levels: hard statistical material on the number of people falling below the poverty level as a result of the crisis is lacking so far. However, some indirect figures give some indication: in a report to its Development Committee, the World Bank estimates that an average drop of economic activity by about 10 per cent in Indonesia, Thailand, Malaysia and the Philippines, will result in a doubling of the number of poor people to more than 90 million (Financial Times [28/9/98, p.4]). More specific figures are becoming available on the country level: regarding the crisis in the Republic of Korea, at least an additional 100.000 people are likely to become recipients of the state's 'livelihood protection scheme'. In Indonesia, it is believed that the crisis would add "a substantial number" of people to the 22 million already living below the poverty line. As such, the crisis threatens to reverse all the achievements in poverty reduction of the last two decades.

price increases due to inflation and import curbs: especially since the last quarter of 1997, increases in basic food prices have started to accelerate, exceeding the rate of increase of overall consumer prices. The price of some basic drugs (which have to be imported) has tripled since the beginning of 1998. In Indonesia, the rice equivalent of the daily minimum wage (Rp.5800) fell from 6.28kg in January 1997 to 4.76kg at the end of December 1997. The import curbs have also hit the availability of basic food, such as rice in Indonesia. As a consequence, the president, Habibie has asked the people to fast twice a week to save on rice.

fragility of social safety nets: due to the absence of a meaningful official social safety net, loss of employment also leads to a large decline in social safety nets, since social security is by and large enjoyed by virtue of formal sector employment. The pressure on existing official schemes will be intensified, in a time where pressure on the overall government budget will not make it easy to ensure that adequate resources are available to meet the intensified demand. In Indonesia for instance, demand for subsidised public health-care service is estimated to double in 1998 to 68% of the population.

increased violence and unrest: increased cases of violence within the family have been reported. Also ethnical tension and violence is increasing considerably; pressure is particularly put on the migrant labour force. The purchasing power decrease of income has also increased illegal activities, prostitution and petty crime.

Source: ILO, The Social Impact of the Asian Financial Crisis. Technical Report for the High-Level Tripartite Meeting on Social Responses to the Financial Crisis in East and South-East Asia (Bangkok, 22-24 April 1998); ILO, World Employment Outlook 1998.

The increased potential for destabilising currency attacks is caused by the world-wide liberalisation of international capital flows, including the trend towards complete abolition of capital controls; it is seen as the virtuous twin sister of liberalised trade flows. This has facilitated global financial speculative behaviour: large sums of money can move largely uncontrolled (and untaxed) around the globe in search of the highest possible return in the shortest amount of time. There is, however, a growing consensus that challenges this positive welfare effect of increased liberalisation. More precisely, a strong case against full liberalisation can be made in the context of stabilising developing countries, which need to manage exchange rates and have relatively underdeveloped financial markets, and where the cost of failed stabilisation is high.

It is essential that an effective sanctioning mechanism, e.g. through taxation, is developed in order to eliminate this behaviour that is driven by individual short-term profit. This is the case not only from an economic viewpoint, but especially from a social justice perspective.

In order to meet this goal, additional action is required because, from a Christian perspective, current national and international policies are insufficient in obtaining the goals. So far, the current politically-preferred option is to maintain international financial order by a mix of strengthened requirements for the provision of information, stricter controls over all financial institutions (and not merely over banks), combined with an officially-financed 'safety net' of (largely IMF) loans. However, this approach has not prevented new currency crises, and it does not attack the speculative nature of financial operations. Instead, it looks more like "officially subsidised speculation, generating private profits and socialised losses, that have to be covered by government funding." (Raffer [1998], p.531).

The recent Russian crisis is a good example of failure to react to the current economic crises. Although this is not just a currency crisis, the ineffectiveness of current (IMF) policy with respect to currency crises is clearly evident here. Despite the country receiving an IMF loan of US$ 22 billion in July 1998, on 17 August 1998, the Russian government decided to devalue the rouble, and allow it to float freely afterwards, with the value of the rouble rapidly depreciating. One slice of the IMF loan, about US$ 4.8 billion, seems to have been fully exhausted by Russia in an unsuccessful attempt to defend the rouble parity by supportive buying of roubles using the dollar (Financial Times [20/8/98, p.1]).

According to financial experts, a transaction levy on financial flows, such as a CTT, could indeed be effective here, as it discourages and/or punishes undesired speculative behaviour. Stabilising capital flows by some sort of global tax instrument could be preferable to current policy, especially when this would also create additional revenue.

However, matters are complicated because not every international financial transaction, even of a speculative nature, is undesirable. Some of these operations lead to more efficiently-functioning markets, such as arbitrage operations, or provide a desired social service, such as allowing end-customers to hedge themselves against financial risks. To give one example, arbitrage transactions can be classified as stabilising. With currencies, such as the dollar or deutschmark, margins can be as little as 3 to 5 basis points (i.e. 0.03% to 0.05%). This means that even a small tax of the same magnitude effectively wipes out this type of operation.

Ideally, an instrument that penalises speculation, e.g. by taxing, should try to discriminate against, and reduce as much as possible, the harmful effects of the system while maintaining its benefits. In particular, it should (at least) avoid 'excessive' swings that lead to a currency crisis with devastating social effects.

2. Lack of available finance to meet global challenges

Many critical problems of today's world have global consequences: solving problems such as environmental degradation, poverty, migration, terrorism, organised crime, and the spread of diseases such as aids, need the global, concerted action of sovereign states, including the will to bear the necessary financial costs of it.

Meeting these challenges, providing the world with what the 1995 World Summit for Social Development in Copenhagen for example calls 'global public (good)s' (3), requires that the existing instruments for international redistribution of resources, such as development aid, which are predominantly national instruments, are complemented by truly global sources of finance (4).

The main reason for moving to additional global sources of finance is the following: the basic concern is that (some) sovereign states default on their contribution to global effort, in the expectation that others will act first and save them the trouble and cost (i.e. to 'free ride'), and that this leads to collective inertia on these matters of global interest. This is typically the case for resources that are decided at the national level, and then redistributed at the global level.

Official Development Assistance (ODA), as a means of reaching the 'global commons' objective of curing world-wide poverty and adequate social development, is a clear example of this. According to the UNDP's Human Development Report 1997, attaining this goal, i.e. providing universal access to basic social services and transfers to alleviate income poverty, is affordable from a purely financial viewpoint: in 1994, the cost of it was estimated at about US$ 80 billion a year over 10 years to 2005 (Human Development Report 1997, box 6.4, p.112); this amounts to less than 0.5% of world income.

Despite repeated calls to and promises by the richer countries to redistribute at least 0.7% of their annual GNP on ODA, realised ODA-flows do not match their targets: for OECD-countries, the current average is 0.3%, which amounts to about US$ 40 billion annually. On world basis, total ODA amounts to about 0.2% of and is steadily declining (especially in real terms, i.e. after correcting for inflation).

Moreover, the benefits of globalisation will not automatically result in more resources being made available to poor countries. For the world as a whole, the benefits of globalisation should clearly exceed the costs. For example, it is estimated that, during 1995-2001, the results of the Uruguay Round of the GATT (General Agreement on Tariffs and Trade) could increase global income by an estimated US$212-510 billion, due to gains from greater efficiency and higher rates of return on capital, as well as from the expansion of trade. However, without an explicit policy of redistribution of the overall gains, they will not result in a win-win situation; rather, it will represent a "complex balance sheet of winners and losers, where the losses tend to be concentrated on a group of countries that can least afford them" (Human Development Report 1997, p.82). It is estimated that, during the same 1995-2001 period, the least developed countries stand to lose up to US$ 600 million a year, and Sub-Saharan Africa up to US$ 1.2 billion.

Without explicit action, resulting in a redistribution of overall gains, a winners-all situation will not be accomplished. An efficient and effective instrument of redistribution can be a truly global source of finance, such as a global tax instrument. Because it generates revenue, a tax instrument, levied on some general tax base or levied more particularly on the cause that hampers attaining the global common, is most appropriate, provided it can be installed in an efficient and effective way.

The more general observations above are clearly illustrated by what is happening now in countries that are struck by a currency crisis. It is difficult to mobilise sufficient finance to cure the social costs of such a crisis and provide for adequate social safety nets. And, more important, in the longer term, only sufficient investment in social development will adequately reduce the vulnerable position of the poor with respect to such crisis situations in the future; here, global sources of finance can provide the necessary additional resources for this.

NOTES

On the contrary, hedging refers to the ability to cover yourself for risk, i.e. an adverse change in the value or price of an asset, by also taking the opposite position by the use of a derivative financial contract, and, as such, in more technical terms 'to close the open position'. As a consequence, the risk is transferred to the counterparty in the derivatives transaction. The main idea of hedging is to transfer the risk to the party that has a comparative advantage in taking that risk. As such, it is an alternative to the insurance mechanism.(Back to text)

This is the result of a kind of asymmetry of returns on speculation: they will reap gain when indeed the speculative attack succeeds, but will not suffer an equivalent loss when it does not, because the value of the currency remains unchanged (Krugman [1998]). (Back to text)

Such as a clean and bio-diverse environment, political freedom, international peace, material and spiritual welfare, and this not only for the people living now but also for future generations.(Back to text)

There is even an evident link between the issue of curbing undesired (currency) speculation and the promotion of global financial resources. Also, the maintenance of an orderly global financial system can be seen as a global common good.(Back to text)

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