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