Will trading rules work in curbing speculation?

Will trading rules work in curbing speculation?

By Ngiam Kee Jin

SINGAPORE: The currency turmoil in Southeast Asia has been blamed squarely on excessive speculation and has prompted calls by Malaysia for some form of trading rules to prevent wild swings in currency values.

The idea of currency trading rules is likely to be deliberated at the meeting of Asian finance ministers and central bankers in Kuala Lumpur this month.

At the moment, it is unclear what specific trading rules will be tabled for discussion. My guess is that Malaysia may advocate one or more of the following measures to curb currency speculation:

* Tobin tax;

* Control on leveraged trading; and

* Shift currency trading to exchanges.

Are these measures workable, and would they help reduce currency volatility?

James Tobin, a Nobel laureate in economics, has proposed a 1 percent tax on all foreign exchange transactions, in order to "put some sand in the wheels of international finance".

As Malaysia is concerned over speculation against the ringgit, it might contemplate imposing a tax on those foreign exchange transactions involving its own currency. As the tax is payable every time the ringgit is converted into another currency and vice versa, it would hurt short-run trading (speculators) more than long-run trading (traders and investors).

It could contain fluctuations in the exchange rate of the ringgit as its trading would be based on the needs of the economy and long-run fundamentals, rather than market sentiment.

The tax, however, has a number of shortcomings.

Firstly, if Malaysia were to act unilaterally, its foreign exchange business involving the ringgit would simply collapse and move overseas.

To be effective, a world-wide agreement is necessary. This will be difficult to achieve because there will always be free- riders who will find it attractive not to participate in the agreement, so as to gain a disproportionate share of the business themselves.

Secondly, the increasing sophistication of the financial markets now allows speculators to bypass the foreign exchange markets and yet take a speculative position.

Thirdly, the tax is too pervasive as it hurt not only speculators, but also traders and investors. By increasing transaction costs, it could also impose a cost on financial markets by inducing investors to hold a less desired portfolio and by potentially reducing stabilizing arbitrage.

Fourthly, since no country has ever imposed a Tobin tax, there is no evidence to suggest that it would be effective in reducing currency fluctuations.

Would the demand for foreign exchange be elastic enough to make the Tobin tax effective?

Empirical observations suggest a week link between transaction costs and volatility.

Take the case of the housing market. Despite its high transaction costs, housing prices appear to be highly volatile.

The modus operandi of speculators is to engage in leveraged trading by borrowing in one currency and converting it into another currency, or by taking positions in derivatives.

Any country may choose to control bank lending in its currency to speculators to contain exchange rate volatility, as this has been a long-standing practice in Singapore and recently in Thailand. This should squeeze hedged funds, which speculate by borrowing the local currency and converting it into dollars.

When the local currency devalues, they would make a profit by selling dollars for the local currency at a higher price.

While the activities of speculators should be curbed, those of traders and investors should be encouraged. The difficulty is how to distinguish speculators from genuine traders and investors.

Any curb on local currency loans may only slow down, but cannot wipe out completely speculation of the local currency as holdings of the local currency deposits can always be converted to other currencies in a currency crisis.

Moreover, speculators can always obtain the local currency loans from other financial centers for speculation. These considerations are especially important for economies which aspire to become major financial centers.

Although derivatives are leveraged instruments, they are invaluable tools for hedging by traders and investors. Hence, any imposition of quantitative limits on their forward or options positions is bound to encounter resistance from them.

To circumvent this ruling, traders can always take positions with several foreign exchange dealers and it would be rather difficult for the authorities to detect. If the control becomes too tight, then the derivatives business would simply move to other countries.

Thus, like the Tobin tax, such a measure would require international cooperation which, again, might be extremely difficult to secure.

Unlike the stock market, which is traded on an exchange, the foreign exchange market is essentially over-the-counter, dealer- driven and non-transparent. When a stock broker executes a trade on behalf of a client, the price and quantity are public information. Foreign exchange dealers are under no obligation to disclose this information. In fact, their ability to earn a living hinges on their skills in gleaning information from other traders.

New disclosures will obviously add to the costs of foreign exchange transactions, but judging from the experience in the stock market, are unlikely to curb currency speculation.

The ability of the over-the-counter market to handle transactions worth about US$1.2 trillion (S$1.88 trillion) daily rests on its low transaction costs and its highly-efficient communication system, which allows currency trades to be arranged and settled quickly.

Although the size of the foreign exchange market seems disproportionately seems disproportionately large compared to the actual trade and investment, much of these involve double-or- triple counting.

For example, a Malaysian importer may buy dollar forward from a dealer in order to hedge his future payment in dollar. The dealer who sells the dollar forward may cover his position by first buying dollar spot and then performing a swap (selling dollar spot and buying dollar forward). In this case, one transaction by the Malaysian importer has generated three additional transactions by the dealer.

Unlike the exchange-traded market, the informal arrangement of over-the-counter market allows contracts to vary according to the desires of the contracting parties.

As the over-the-counter market has served the needs of market participants well and has operated so efficiently for so long, it would be an uphill task to attempt to channel currency trading to the exchanges. Any impediment to over-the-counter trading by any country would surely result in its currency trading moving to other financial centers.

Except for controlling the lending of the domestic currency, all the other measures presented are unlikely to be put into practice.

Not only is it not obvious that these measures will reduce the degree of exchange rate volatility, the practical problems of implementing them in a world of increasing financial sophistication are overwhelming

The solution to currency speculation does not seem to lie with currency trading rules, but rather, with building strong economic fundamentals, such as high savings and fiscal prudence, coupled with some of exchange rate and monetary cooperation among nations, such as the one between Singapore and Brunei.

The writer is a senior lecturer in the Department of Economics & Statistics, National University of Singapore.

-- The Straits Times