South Korea Proposed 14% Withholding Tax Puts Spotlight on 'Currency War'

Nov.10.10 | About: iShares MSCI (EWY)

Bloomberg notes:

South Korea may revive a 14 percent tax on domestic Treasury and central bank bonds held by foreigners as early as January to curb foreign-exchange volatility, a ruling party lawmaker said.

“If we don’t do it right now and the situation worsens, we may have to set up higher barricades,”Kim Song Sik, a member of the Grand National Party and the legislature’s financial committee, said in an interview yesterday in Seoul. He also called on the central bank to raise interest rates to head off asset-price bubbles.

The bonds initiative is part of a series of measures across Asia aimed at defusing the danger of hot money, or inflows of capital that push up currency and asset values in the search for short-term gains. Taiwan yesterday said it will restore curbs on foreign investment in its debt, only allowing offshore funds to have as much as 30 percent of their portfolios invested in all types of government bonds and money-market products.

Kim said that a bill to resurrect South Korea’s levy will be submitted to parliament this weekend or early next week, and predicted passage by the end of the year.

“What I’m proposing is a predictable and reasonable hurdle for capital flows in and out of the nation,” Kim said.

The South Korean floats, so the capital control issue is not just for nations with currency pegs like China. China has a peg. So clearly, they could reduce the pressure on their economy by allowing their exchange rate to appreciate. However, this would put them at a competitive disadvantage on exports vis-a-vis other Asian exporters. But, countries like Brazil and South Korea, which have floating exchange rates versus the major currencies are also feeling the effects of excess monetary liquidity. Below is a world map and legend on pegs from Wikipedia (click to enlarge).

Foreign-Currency-uses-and-pegs

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Despite the fact that flexible exchange rates are supposed to automatically adjust trade balances in theory, we can see that the trade imbalances remain. So clearly, there is more to trade than just exchange rates. For example, there are non-exchange rate barriers to competition like subsidies. We see this in agriculture in the US and the EU. Japan is well-known to have a lot of non-tariff, non-exchange rate barriers to competition which enhance its current account surplus.

My point is that flexible exchange rates alone will not alter the landscape completely, although they will help. Geithner’s proposal of targeting imbalances directly is more to the point. In an internal economy, you see large current account imbalances all the time. But, because there are no exchange rates across borders and a free flow of labour, these imbalances are not a political issue. The Europeans thought they could get the benefits from this by enacting the Euro, but we see the tension remains because of distinct national identities.

Over the long-term, the proposed European Monetary Fund makes sense. However, first and foremost, let’s call it a European Harmonisation Fund because this is the purpose – harmonisation.

For example, within the United States, I imagine there are substantial interstate capital account imbalances between individual states. Florida might have a substantial capital account surplus because of all of the retirees moving there. While New York could have a capital account deficit because of the financial sector wealth. (I don’t know if this is true. The example is just illustrative). But you wouldn’t hear New Yorkers screaming bloody murder about the profligacy of Florida. Nor would you hear the Floridians yelling about New York’s enormous current account surplus.

The point is the United States has more well-harmonised internal market because of the free movement of labour and capital, a common language and federal automatic stabilisers. This is what the Eurozone lacks. And this is why we can change the unbelievable EMF – and its inflammatory expulsion clause into the more believable EHF.

-The politicization of economic problems

Internationally, if we had a pledge and a mechanism to eliminate trade imbalances, a lot of the "currency war" rhetoric would disappear.