Select Committee on International Development Minutes of Evidence

Letter from Professor Spahn to the Committee Specialist

  I have the pleasure of responding to your questions as follows:

  1.   One question which was asked to Professor Spahn but not answered at any length was "what makes you think that the imposition of a tax wouldn't lead the FOREX markets to migrate in the same way as dollar banking moved to Europe and generated the Eurodollar markets in the 1960s/70s"?

  Answer:  There are many factors that explain the emergence of the Eurodollar market in the 1960s/1970s:

    —  First, there were unremunerated minimum reserve requirements on bank deposits to be held at the Fed.[18] This imposed a charge on US dollar holdings in bank accounts within the US. Elsewhere it would not apply, so there was a trend to migrate to other places in Europe (and Asia). The cost advantage is not only confined to injections of primary liquidity into the Eurodollar market (US dollars flowing to Europe), it also applies to all credit operations that are based on this primary liquidity (and the credit-multiplier was very high in this market).

    —  The same would of course also apply to holdings of DM in Germany, Pound sterling in the UK, Francs in France, etc, so there was a trend to leave domestic currency markets all over the world. It led to a concentration of foreign currencies in London, mainly because it was (and is) the largest financial centre that benefits from a number of structural and institutional advantages. In particular it had (and has) the deepest and most liquid wholesale market in the world, where both creditors and borrowers can benefit from substantial economies of scale.

    —  Other reasons for the dollar to go overseas were related to structural deficiencies of the US financial markets (now partly removed). There was a cap on the interest rate for savings deposits (regulation Q), but this could largely be circumvented by other instruments (eg, money market funds) even in the US. There seems to be agreement that the temporary interest-rate equalisation tax of the 1960s was largely ineffectual. Other obstacles were more difficult to deal with, in particular the regional segmentation of the capital market. (As late as 1979 there was legislation pending in the US Congress to forbid national non-bank holdings that were organising supra-regional liquidity clearing!)

    —  Finally, in the early 1970s, the depositors of petrodollars preferred London to New York for convenience and political aspects. Some oil producers feared political coercion by the United States, even sequestration of their assets, a concern that was shared by the Soviet Union and other socialist countries that would also prefer London for their dollar holdings.

  This set of conditions (only partly financial) cannot be compared with a situation where a 0.01 percent charge would be levied on transactions (which is of course negligible for the long-term investor who was then much harder hit by the implicit charge of reserve requirements).

  2.   It was mentioned that a recent proposal sees the tax as being a percentage of the bid-ask spread, rather than a percentage of the total transaction. Please could you provide the Committee with a short clear explanation of this? Also, is this a Schmidt-inspired proposal?

  Answer:  I am afraid the answer is not short. I may have been contributing to this idea myself because in hearings last year I wanted to draw the attention to the fact that bid/ask spreads differ for various currency pairs. And I had argued that a transactions tax on the bid/ask could be interpreted as a presumptive gross income tax (in order to convince those that are against the CTT, but raise concern about the loss of sovereignty in taxing the returns on international capital investments under globalisation). I have revised this position mainly on the following grounds:

    —  While the bid/ask is known at any one moment, it cannot be applied to one single transaction, because the conditions for traders may have been different when taking an open position from those at the time of closing the position. The profit margin may be greater than the bid/ask, it could even be negative.

    —  The margin varies during the day, it is different among different types of traders, and even for individual clients. The bid/ask for liquidity traders is normally much lower than for dealings with non-financial institutions.

    —  There is no record on the margin by trade (even if it were, I am horrified by the reporting requirements). The only alternative is then to tax the accumulated margins at the end of the business day. It would come close to taxing gross income on a daily basis. This would not represent a transactions tax, so the benefits of driving out smaller noise traders would be lost. Even if done once a day, it would be too much reporting and too much intrusion into the banking business. And, of course, a tax rate on the accumulated margins would have to be much higher than any transactions tax rate (if the top income tax rate were 30 per cent, the tax rate on the accumulated margins as an indicator of gross profits could be as high as 20-25 per cent). This would work as a huge deterrent.

    —  Finally, since the margin is known neither to the trader at the desk, nor at the point of settlement, the tax would have to be levied at the back office, the only place to possess the information. But most actors agree that a back office (unlike the trading desk and/or the clearing/settlement operator) is much more difficult to control, and it could indeed be more easily shifted out of the jurisdiction.

  There is also concern that a CTT would hit emerging and developing countries more heavily, and therefore some propose to exempt this market altogether. One has to realize however that these smaller and much less liquid markets operate with enormous bid/asks (often in the order of percentage points rather than basis points). If a tax were put on the margins of these tradings, it would particularly penalise the Third World. (The reporting requirements would of course abort such an attempt. Fortunately! Because I am strictly against too much reporting and certification in developing countries, since it encourages corruption!)

  3.   Finally, there's a question about the width of the corridor in the two-tier variant, and the rate of change allowed in the target and hence the corridor (which also determines the sorts of speculation which is deemed excessive). Is it your feeling that such issues are political rather than technical?

  Answer:  Since I assume this tax to be implemented unilaterally, the political implementation is easier than for a coordinated approach. A parliament (say, that of Brazil) could determine the anchor currency (US dollar, or a mix of US dollars and other currencies), it would determine the period for the moving average and its weights to calculate tomorrow's target rate, and it would fix the corridor. While this can be viewed to represent a technical problem, it has of course political implications.

    —  The basket of currencies for anchoring is decisive for the direction of trade and capital market policies (which is a political aspects).

    —  The moving average may be seen to represent a purely technical matter. But the length of the moving average and the weights (one could put equal weight on the daily information, or weigh more recent information more strongly) will be decisive for the time profile of the longer-term devaluation/revaluation of the exchange rate (a political question). The longer the moving average and the heavier the weights placed on historical information, the closer the scheme comes to a fixed-exchange rate system; the shorter the period of adaption and the heavier the weights on more recent information, the faster can the target rate incorporate new information about fundamentals, and react correspondingly. I think something like 20-30 business days could be appropriate.[19]

    —  Also the corridor is a matter of practicality. I suggest to make an empirical study on the daily fluctuation of a currency during phases of normal trading (which is a technical matter), but allow some margin of tolerance (say, twice the normal variability) to avoid the tax to be triggered too often (a political decision).

  Thank you for your challenging questions. I hope to have served your purposes.

Professor Spahn

4 May 2002

18   As an aside: the implicit charge is proportional to the maturity of the deposit, so it penalises long-term holdings more than short-term commitments, which runs counter to the idea of Tobin. Back

19   One could also imagine the conditions to be phased in. In Argentina, for instance, I proposed (in 1996!) to move from the fixed-exchange rate currency board system to a more flexible peg be starting with long periods for the moving average, and shorten it over time to render it more flexible. Back

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