Brazil’s recent decision to impose a two per cent tax on portfolio inflows has wide ranging implications for global finance and for countries such as India. The move is aimed at arresting the sharp appreciation of its currency, the real, which since the beginning of the year has gained 36 per cent against the dollar, undermining Brazil’s export competitiveness. This is not the first time that a major developing country has imposed restrictions on foreign inflows. In 1998, during the Asian currency crisis, Malaysia defied financial orthodoxy and imposed controls in a successful attempt to curb currency speculation, which devastated many of its neighbours. Until recently, Chile, the most successful of the Latin American economies, had required a portion of the foreign investment flows to be kept in an interest-free account with its central bank for a fixed period. The intention behind such controls is to keep a check on footloose global capital that, given both its large volumes and propensity to move in and out of a country in a matter of seconds, threatens macroeconomic management. It also signals a desire to be less dependent on certain types of foreign capital that is less stable. Over the medium-term, if properly implemented, these curbs could add to the repertoire of weapons that governments deploy to prevent asset bubbles.
The intellectual basis for the tax is found in the work of the influential U.S. economist and Nobel prize winner, James Tobin who in the early 1970s proposed a small tax — even as low as 0.1 per cent — on foreign exchange transactions to reduce volatility in the markets. Until the Asian crisis, the idea was not popular and even after that it had only sporadic political support. Recently, however, the G20 has asked the IMF to examine such proposals. Well endowed with natural resources, Brazil is having a commodity boom and is among the first countries to come out of the recession. Prudent macroeconomic management over the years has delivered low inflation and created a large middle class. As with India, Brazil’s attractiveness to foreign portfolio investors has not been an unmixed blessing. The rupee, like the Brazilian real, has gone up significantly against the dollar. The very large dependence of the stock market on these portfolio flows has been a major cause for concern. The RBI has been assessing the various flows on the basis of their liquidity profiles and risks. The time for a Tobin tax in India may not have come but its underlying principle can no longer be dismissed as being retrograde and impractical.