China may be shooting itself in the foot again as it tries to control the market. A plan to introduce a Tobin tax on yuan trading may increase volatility instead of reducing it. It may also push more currency trading overseas, making it increasingly difficult for the People's Bank to keep the offshore exchange rate aligned with the onshore one.
China’s central bank has drafted rules for a tax on foreign-exchange transactions to curb currency speculation, Bloomberg News reported on Tuesday. The initial rate of the Tobin tax may be kept at zero to allow authorities time to refine the rules, people with knowledge of the matter said. In other words, for now Beijing will use it simply to monitor who's trading yuan and by how much in its usual fashion of market control, which starts with getting full transparency on who's active in it.
It's suggested the tax is not designed to disrupt hedging and other foreign-exchange transactions undertaken by companies. But it's sure to. As concluded by Albina Danilova and Christian Julliard in a study, a transaction tax alters the price of financial assets, making it tougher to assess their fair value. In other words, with more uncertainty about the future value of the yuan, banks that help companies hedge their exposure to the currency are likely to charge more for the service.
Then there's the issue of liquidity. It stands to reason that adding a tax, or even more oversight and reporting required at the zero rate, will deter people from trading unless they need to. That's what London School of Economics professors Danilova and Julliard called the creation of quiet periods and busy spikes in the market, both signs of a lack of liquidity. An illiquid market is inherently more volatile since smaller or fewer trades have a larger effect on prices.
Onshore trading volume is already very spotty, as can be seen in the numbers of the China Foreign Exchange Trade System:
In the final analysis, questions are bound to be asked about the motivation behind the tax, and its timing. Given there was an estimated $1 trillion of outflows from the mainland last year, investors have wondered if China will erect stronger capital controls to prevent an exodus of money.
The upside of a transaction tax, from authorities' perspective, is that they might be able to keep the onshore exchange rate on a tighter leash. But if in doing so the gap with the currency's value offshore once again widens to the elevated levels last seen in early January, there will be legitimate worries about whether the International Monetary Fund has been premature in deciding to make the yuan a part of its currency basket. As for investors, they'll undoubtedly view any levy as a sign of desperation, no matter what spin the People's Bank puts on it.
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