7:36 AM Jan 9, 1996

CAPITAL MOBILITY INCOMPATIBLE WITH FREE TRADE

Geneva Jan 8 (Chakravarthi Raghavan) -- The containment of international capital mobility is more than ever a sine qua non for stable exchange rates and reasonably free trade, according to a leading US academic and expert in monetary and financial issues.

In an UNCTAD discussion paper, "Financial Globalization versus Free Trade: The Case for the Tobin Tax", Prof. David Felix of the Washington University, St. Louis, USA, points out that financial globalization has not integrated capital markets in terms of transfers of real resources nor brought about global convergence of real interest rates, but has increased exchange rate volatility, in turn increasing pressures for administrative protection against competing imports and pressures on developing countries to open up their markets speedily.

Prof Felix argues that current proposals of the IMF and G-7 monetary authorities, to stabilize exchange rates and promote free trade without curbing international capital mobility are exercises in squaring the circle.

"Even worse," Prof Felix contends, "the successive governmental bailouts of international financial markets from the crisis to which they have become increasingly prone have been raising moral hazard risks, encouraging yet greater speculative flows. They increase the prospect that future crises may exceed the fire-fighting capability of the G-7 monetary authorities.

"The most recent bailout, that of December 1994 Mexican crisis, should be a wake-up call to 'put sand in the gears of the well-greased wheels of the international financial market mechanism', so as to slow its responses as an imperative first step towards bringing stability to the international monetary system," Prof Felix says.

Towards this end, Prof Felix commends the levy of a globally uniform Tobin tax, at a low 0.25% rate on all private forward as well as spot Foreign Exchange (Forex) transactions. Such a tax, levied by agreement of the major financial centre countries, on all private forward and spot Foreign Exchange (Forex) transactions within their jurisdictions, Prof Felix argues, would not distort market behaviour or reduce global allocative efficiency, but would slow down reaction speed of global financial markets and roll back the volume of Forex transactions.

The US academic disputes the view that the tax would be easily evaded and unworkable and says that the centre countries could control evasive offshore deals (booked in island havens from main offices) while possible revenue leakage by relocating Forex trading to offshore havens would be expensive, and would develop only slowly -- giving mainland authorities time to take counter-measures.

The Bretton Woods system, he notes, was based on the experience of the interwar years -- hot money flows destabilizing the post-World War I gold exchange system, and contributing crucially to its breakup and to the parallel breakdown of multilateral trade in the 1930s. The Bretton Woods currency system was built on the premise that stable convertible exchange rates were essential for restoring relatively free multilateral trade and long-term foreign investment, and that capital controls would be required as a permanent deterrent against currency speculation that threatened exchange rate stability. The stable exchange rate objective was, however, modified by a third premise, that the domestic socio-political climate of the industrial countries, transformed by the Great Depression and World War II, no longer allowed defending a fixed exchange rate to take precedence over full employment and social welfare policies.

The key elements included Art. 6 (of the IMF articles), allowing members to curb access to their currency for international capital transactions, with the IMF instructed to prevent its credits from being used to finance capital flight. An initial draft (agreed to by J.M. Keynes and Harry White) enjoined the IMF and members to help enforce each other's controls against capital flight, but this weakened in the final version under pressure from the US State Department, New York Federal Reserve and Wall Street bankers.

But the symmetry of the formal Bretton Woods arrangements quickly gave way before asymmetrical reality. The IMF, kept short on financial rations, exercised supervisory functions asymmetrically. It lacked the financial clout to discipline the industrial powers. It was only able to affect policies in the Third World by conditioning its emergency credits on their implementing IMF-approved policies. As such, the IMF served as a useful instrument for imposing Washington's policy line on the Third World.

But the IMF policy package changed over time, more or less in step with changes in Washington's policy line and, in the course of this, "the intent of Art 6 of the IMF charter has been completely inverted."

In the 1960s, a standard IMF condition was for the applicant to abolish import quotas, adjust the dollar exchange rate and make it freely convertible for all current account transactions, usually on an agreed implementation schedule. With the floating exchange rate system, the IMF policy shifted in the 1970s and early 1980s to "getting prices right" i.e. letting exchange rate to float to balance demand and supply. But with explosion of international capital flows in the past decade, the emphasis again shifted -- this time to augment the supplicant economy's attractiveness to international capital by lifting capital controls and either stabilizing the nominal exchange rate or pre-announcing its adjustment schedule to reduce exchange rate risks to portfolio investors.

In addition, the IMF credit facilities were enlarged to provide quicker and easier credit assistance to supplicants under siege from capital flight who might otherwise be tempted to reimpose capital controls.

But floating exchange rate system resulted in "pervasive growth retardation" -- limited during 1972-1981 to the OECD and sub-Saharan African countries, but extending during 1982-1991, to Latin America and North Africa/Middle East. Asia was the exception: with mild growth retardation in East/South-East Asian group of countries in 1982-1991, and acceleration in both periods for South Asia.

There was a decline of investment/GDP ratios in the OECD and Latin American countries; the ratios rose in most of East/South-East Asian and North Africa/Middle Eastern countries. South Asian and sub-Saharan African countries balanced between retardation and acceleration.

For the New Classical Macroeconomists, floating the exchange rate and lifting capital controls were inexorable advances to a more efficient international monetary system.

But by mid-1980s, it was becoming difficult to disregard that, despite the favourable turn in their terms of trade, G-7 exchange rate volatility kept increasing; despite explosive expansion of international capital flows, volatile real interest rates were not converging; and exchange rate volatility was fuelling stealth protectionism through an increasing resort to non-tariff administrative controls.

As a result, support for floating rates began eroding, and sentiment began emerging for stabilizing exchange rates over a wider area. Beginning with the 1985 Plaza agreement of G-5, repeated efforts of G-2, G-3, G-5 and G-7 monetary authorities to intervene to impose more stable rates met with little success.

This has led the IMF and other mainstream economic think tanks to proffer proposals on how to do it more effectively. But, in contrast to the Bretton Woods, the proposals and efforts take as a precondition that stabilization not restrict freedom of financial capital to move globally.

The IMF even wants to expand that freedom and proposes combining coordinated stabilizing of key exchange rates with replacing Art. 6 with a requirement that all members make currencies freely convertible for all capital as well as current account transactions -- "to lock in freedom of capital movement already achieved and encourage wider liberalization".

"The latest (IMF) shift stands Art. 6 completely on its head," Felix remarks.

Others, less enthusiastic about benefits of global financial liberalisation, view global financial markets warily.

In either case, constraining international capital mobility has not thus far been part of the mainstream stabilization plans.

A survey of global Forex trades shows by 1992 per trading day it had reached $880 billion or a 4800 percent increase over 1977 -- with preliminary results for 1995 indicating a further 45% rise over 1992. For 250 trading days, annual Forex trading reached an astonishing $220 trillion, while global exports as a percentage of Forex trading declined from a sizeable 28.5% in 1977 to a minuscule 1.7% in 1992.

Over 81% of global forex transactions in 1992 were for round-trips of seven days or less. Almost three-fourths of both spot and swap transactions in 1992 were inter-dealer rather than dealer-final customer transactions. Only one-eighth of the global trades in 1992 were dealer transactions with other financial institutions, which suggests that central banks were probably involved in less than 10% of global Forex transactions that year.

Growth of Forex trading thus has been mostly motivated by other objectives than servicing direct financing requirements of the 'real' sector activities.

But while capital markets are becoming highly integrated and there is increasing concern that local bank failures and currency shocks may instigate global crises, all such evidence relates only to financial asset markets.

In terms of international transfer of real resources, there is little evidence that capital markets have become much more integrated. Rather there is evidence that investment is as highly correlated with national savings in the 1970s as in the 1960s, and that correlation declined only slightly in the 1980s when international financial flows were rising explosively.

These findings, Felix notes, are now accepted as generally valid.

The inference for policy is that countries should not rely on foreign financial markets to fill large prolonged short-falls between domestic investment and savings. The high ratios of global official reserves to exports is additional evidence that capital markets are not well integrated internationally.

The expected global convergence of real interest rates has also not been happening. The average volatility of both short and long-term real exchange rates of the G-7 rose after the demise of the Bretton Woods. There is no tendency for the inter-country variance to diminish and real interest rates to converge globally. Neither have real exchange rates been converging on purchasing power 'equilibrium' rates.

Forex transaction costs have declined substantially - with fees lowest for wholesale transactions and rising for smaller transactions which may be charged as much as one percent of value of transactions. But risk premia and risk-offsetting outlays on hedging have been rising.

The combined effect has been to greatly alter the composition as well as promote growth of global Forex trading, while its effect on growth of volume of world trade has been adverse.

While the explosive growth of global Forex transactions has attenuated its linkage with growth in the value of world trade, it has not pulled up the volume of trade. Rather the reverse has happened. Export growth in constant dollars fell from an average annual rate of 23% during 1977-1983, when Forex expansion was gathering steam, to 5% during 1983-1992 when Forex expansion was in full throttle.

According to a survey of Fortune 500 companies, foreign exchange risks was a dominant worry. This explains why business pressure for administrative protection from foreign competition has intensified. with rising volatility of exchange rates.

Financial globalization has slowed growth of domestic output and income around the globe and retarded global growth of demand for foreign products.

The subordination of monetary policy to flawed financial market expectations and the working hypothesis that most product markets are oligopolistic helps explain why inflationary component of nominal income has been so resistant to falling real wages and unit labour costs, and why estimates of NAIRU (the non-accelerating inflation rate of unemployment), has risen over the past two decades in OECD economies, despite weakened unions, slackening real wages and surge of 'third wave' of technological innovations, Felix says.

Inflation has been receding slowly and unevenly, but at high social cost - with current monetary policy leaving productive capacity and labour under-utilized.

The floating rate exchange rate regime has by now lost most of its supporters in policy circles and, perhaps to a lesser degree, among academics. Many proposals have been mooted for stabilizing exchange rates, but hovering over them is the spectre of the Bretton Woods.

The proposal of the IMF Managing Director for reform (aired at last year's annual meetings in Spain) is for coordinated stabilization of key exchange rates with the requirement that members make their currencies freely convertible for all capital as well as current account transactions. But it ignores not merely interwar experience with hot money, but the post-Bretton Woods experience that financial markets have built-in destabilizing properties. In asking the G-7 to make defense of a coordinated realignment of exchange rates the primary focus of domestic monetary-fiscal policy, the IMF proposal is asking for a level of political commitment for exchange rate stability far greater than what was needed to save the Bretton Woods regime during its terminal crisis.

Other mainstream proposals are less enthusiastic about capital mobility, but treat the markets as a global financial gorilla too big to tackle. Their coordination requirements are as demanding as the IMF's.

Coexistence with the status quo is not viable. The status quo is not self-correcting or stable.

Between 1973 and 1989, the IMF identified eight crises (six of them in the 1980s) whose spillover threats evoked coordinated international crisis management. The first half of the 1990s has added atleast three more -- the ERM crisis, the collapse of Barings and the Mexican crisis and other lurking (Japan's banking crisis and Argentina's currency board tribulations).

In the Mexican crisis, the government was offered up to $52 billion of new dollar credits by the US, IMF and the BIS - on condition that it continue supplying dollars on demand to foreign and domestic banks of $30 billion Tesobonos anxious to liquidate and exit into dollars. Since Mexico had only to provide pesos on maturity to holders, it could have moderated the peso's fall by curbing use of its reserves for capital flight (as it is authorized to do under Art.6 of the IMF agreement). As a result Mexico has been saddled with a large increase of its already burdensome foreign debt in order to reduce dollar losses to Tesobono holders. Thus comforted, mutual funds are now reported to be venturing again into Mexico.

With the reserves/Forex rations dwindling in importance, and the IMF and G-7 monetary authorities persisting with a crisis management strategy that encourages riskier global financial forays, the likelihood of a future crisis exceeding the crisis management resources of monetary authorities is becoming uncomfortably high.

Rolling back the global Forex volume and slowing the reaction speed of global financial markets is needed to reduce that likelihood and is an essential precondition for any of the mainstream stabilization programs to become viable.

The Tobin proposal, for a small tax at a globally uniform rate on all Forex transactions involving short round trips, was advanced in the 1970s to slow down the reaction speed of global financial markets and roll back volume of Forex transactions.

Critics first dismissed it as an uncollectible tax - since Forex dealers could quickly move to tax havens. But now with growing interest in the proposal, criticism is widening that the tax would distort market behaviour, would increase exchange rate volatility by reducing liquidity, reduce global allocative efficiency and encourage inflation. But all this presumes the tax is collectable.

Felix argues that the adverse effects would not be true of a low, 0.25% tax rate, levied on forward as well as spot transactions, and involving agreement of major financial centre countries to levy the tax on all private spot and forward transactions within their jurisdictions.

The revenue leakage from evasion would develop only slowly -- since it involves physically relocating Forex trading to an offshore haven (as distinct from merely booking at an offshore office transactions developed at home) and it is an expensive, high-risk operation. It involves external diseconomies: bonuses to attract professional traders, backroom 'financial engineers', technical and clerical staff, higher equipment maintenance costs, higher transportation costs plus contract enforcement difficulties.

But almost 80% of the global Forex trading is carried out in seven financial centre countries and an agreement among them would suffice to keep the offshore relocation threat a relatively distant one. Booking offshore deals can be readily controlled by home authorities -- since various island havens are merely booking addresses that function because mainland authorities have tolerated such evasive tactics by banks and TNCs. The mainland authorities need only to supervise a manageable small number of dealer institutions.

While attempts by rogue traders to evade the tax is to be expected, large trading institutions are unlikely to risk their reputations to avoid a small tax. They may attempt to push against legal limits through financial innovation, but not blatantly violate them. But innovations take time to develop and spread, providing time for alert authorities to check the spread with counter-measures. Doubling the tax rate when the address of one of the counter-parties is in a tax-free haven could also be used to discourage offshore booking.

But the Tobin tax is only an essential first step for followup measures needed to solidify a more stable international financial system. It complements more ambitious coordination proposals to address other requirements. If successfully implemented, it could among others help create the political momentum to politically make feasible more ambitious coordination proposals, It could for example make operational the IIE proposal to fix economically consistent exchange rates and target zones for major currencies, with coordinated central bank interventions and monetary-fiscal political adjustments to prevent future currency misalignments.

Cooperating in the levy of such a globalized tax, Felix argues, is also in the interest of developing countries who are not equipped to be major actors in efforts to stabilize exchange rates and international financial flows, but have suffered even more than the advanced economies from international volatility.

A Tobin tax, jointly levied by developing countries with money centre countries, would curtail two volatile type of portfolio investing in developing countries: interest rate arbitrage and pen end 'emerging markets' mutual funds. The curtailment of the first would be moderate, but it would quite substantially curtail open-end emerging market mutual funds which are an excessively volatile source of external funds.

But the main gain of a globalized Tobin tax for developing countries would be indirect. By making full employment policies of industrial countries viable again, it would not only advance broader efforts to stabilize the global financial system, but also weaken the neo-merantalist pressures motivating much of the current drive for trade expansion to the detriment of developing countries.

This would slacken demands in industrial countries for protection against low wage imports and would soften pressures on developing countries to open up their markets and lift capital controls. This will give these countries more scope for opening up at a more gradual pace compatible with the needs of developing economies trying to moderate socioeconomic disruption and inequalities of income and wealth as they climb up the technological ladder.