As China contemplates an exchange tax, psychology meets economic reality
April 6, 2016
In an effort to limit speculative currency trading, the People’s Bank of China (PBOC) has announced that it is considering levying a tax on foreign exchange transactions that seek to profit from the difference between the yuan’s exchange rate at home and its exchange rate abroad.
While the PBOC has indicated they are studying the possibility of implementing this tax, known as a Tobin tax, as of yet, there is no clear-cut effective date. Whether China moves forward on implementation of the tax will likely depend on changes in currency movements and speculative capital flows.
Our take on the tax and what it means
Two historical episodes of a Tobin-like tax are generally recognized as good examples of how the tax works. One happened in Chile in the mid-1990s, and another happened in Thailand in the late 2000s. In each case, central banks introduced so-called “unremunerated reserve requirements (URRs)” on capital inflows.
Under the agreements, the interest on the reserves effectively became a tax, meant to stifle the amount of “hot money” inflows that were driving excessive currency appreciation. We believe neither example was particularly successful in stopping inflows or preventing significant currency appreciation.
A closer look at the possible economic effects of a Tobin tax suggests that media accounts may be overemphasizing its near-term relevance. Here are two points that help explain what we mean:
- Last year’s reserve requirement on foreign exchange forward contracts is already an example of a Tobin tax, so the measure recently announced will basically be an extension of an existing tax. The levy will be aimed at curbing capital outflows, which are being driven by pressure on the yuan as well as a slowing economy. That said, sentiment on the yuan has improved lately, and if U.S. dollar strength does not return meaningfully, expectations for yuan depreciation may ease in the near term and perhaps bring outflows down as well. Indeed, data for recent months show that a slowdown is already in motion, with outflows slowing from $100 billion in January to $30 billion in February.
- In terms of its possible effects on the Chinese economy, the exact nature of the tax is not clear enough to allow us to confidently predict probable consequences. Furthermore, we are seeing speculation that the Tobin tax would initially be set at a rate of zero, allowing currency traders to become accustomed to the concept of the tax in the first place — in which case it would probably not have any immediate economic effect.
No repercussions for equities either?
From an equity market perspective, the prospect of a Tobin tax may be marginally negative for investor sentiment but we don’t think the tax will ultimately be a significant issue. Despite the negative headlines and worrisome news reports, we remind investors to keep in mind that (1) foreign ownership of the A-share market is still quite small (less than 3% of the total market capitalization), and (2) at the company level, the Tobin tax may have little influence on earnings. This last point is an important part of our analysis, because any policy move that could potentially harm earnings would get a lot of scrutiny from us. In this case, investors should know that we don’t see obvious warning flags at this point.
Waiting for the green light ... but until then, more of the same
The imposition of a Tobin tax has long been studied by Chinese policymakers, and indeed the PBOC has drafted a set of rules that set the stage for implementation at will. However, the question of when to roll out the tax is still uncertain and will very likely depend on changes in market conditions as noted at the beginning of this commentary.
For financial markets, we think the new measure will probably have a larger psychological effect than a genuine tangible impact, especially if the tax rate is set at zero in the beginning. It’s also worth noting that foreign direct investment and long-term capital investments will not be subject to the tax; the policy’s goal is mainly to curb currency speculations.
One way to view the Tobin tax, in our view, is as a stop-gap measure that might be added to other central bank actions that have been put in motion as of late. For policymakers, we think the key focus should continue to be on domestic monetary policies and liquidity, in an effort to ease speculation over yuan weakness. (Communicating a sense of confidence is key when managing currency policies, and we think such communication is missing today.)
Further policy steps are likely to address asset quality issues in the banking sector as well as overhauls of industries that are struggling with overcapacity. All in all, this continues pointing to a two-speed economy in China, with the consumer responsible for driving incremental growth. Accordingly, we continue to see better investment opportunities related to Chinese consumers, especially outbound spending areas such as tourism and lifestyle expenditures. (For a better look at the rise of Chinese tourism in recent years, see this chart that accompanied our recent Insight, More quantitative easing, China style.)
The views expressed represent the Manager's assessment of the market environment as of April 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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