Experts disagree on the benefits and harm of Brazil's new foreign investment tax.
BY LATIN AMERICA ADVISOR
Brazil's government [recently] announced a 2 percent tax on foreign investment in local stocks and fixed-income securities in a bid to slow the appreciation of Brazil's currency. Was the tax the right move for the country's economy? What will be the short- and long-term effects of the measure, and what are the downsides? Could Brazil's new tax divert investment flows to other emerging markets in the region?
John Williamson, senior fellow at the Peterson Institute for International Economics in Washington: Last time it was Chile, this time around it is Brazil that has taken the lead in the attempt to maintain a competitive exchange rate when faced by a surge of capital inflows. Specifically, Brazil has reimposed, extended and increased the tax rate on capital attempting to enter the country. In the future, anyone bringing in money to invest in either the equity or the fixed-income market will be required to pay a 2 percent tax rate to the government. Economists have never agreed on whether the Chilean encaje was effective in reducing the weight of money attempting to enter Chile, and hence whether it gave additional latitude to the Chilean government to run a tight monetary policy without making the exchange rate hopelessly uncompetitive. (They did manage to agree that it did something to lengthen the maturity of the debt, so let us be grateful for small mercies.) Doubtless there will be a similar never-ending dispute about the effectiveness of the Brazilian measures. No one expects them to work perfectly, but they don't have to in order to have a worthwhile impact on the policies that countries are able to pursue. Assuming that the measures have an effect, they are exactly what Brazil needs at this time. The exchange rate is overvalued; demand threatens to expand so much as to throttle investment; foreign demand for assets is pushing their prices out of reach of ordinary Brazilians. All these problems will be addressed to some extent, though it remains possible that further measures—like an increased tax rate at some time in the future—will prove desirable.
Guillermo Calvo, professor of economics, international and public affairs at Columbia University and former chief economist at the Inter-American Development Bank: Several empirical studies show that taxes on capital inflows have little effect on total flows and, therefore, are unlikely to succeed in slowing down the appreciation of Brazil's currency. Part of the reason is that there is a variety of tricks multinational firms, for example, can employ to bypass the tax. Why not intervene in the foreign exchange market in order to prevent nominal appreciation in the short run? I suspect that the answer is fear of inflation in an election year. This is unfortunate because, without capital controls, exchange-rate pegging ensures that there is no sudden real appreciation and, most importantly, there is no discrimination between sectors or firm sizes. Moreover, unless widespread indexation mechanisms are triggered, a capital-inflow episode gives rise to a one-off price rise, not inflation. Typically, however, capital inflows bring about a sharp acceleration of bank credit and lax credit standards. This sets the stage for domestic bank crises when capital flows in the opposite direction. These crises could be very costly because they might seriously impair the domestic payments system or force a massive bank bailout and a major hike in prices and wages. Therefore, it would be prudent for the central bank to implement policies that would help to slow down bank credit, such as an increase in banks' liquidity requirements or a tax on credit expansion, like in Spain. These policies will not prevent a large increase in credit but will help to improve credit quality by alleviating the strain on regulatory resources that a major spurt of credit may generate. These credit policies are advisable even if taxes on capital inflows are implemented.
Claudio Loser, visiting senior fellow at the Inter-American Dialogue: Brazil finds itself coming out of the recession early, helped by its growing links to China. In large part because of this, the real has appreciated markedly in recent months. In a situation where the world economy is still weak, and Brazil loses competitiveness against the United States and China, Brazil is concerned about its ability to continue exporting. Moreover, as the real becomes stronger, investors are betting that it will continue to do so, and more capital comes in. That is the logic behind the new tax on inflows. But the experience with these taxes is at best mixed. Chile introduced it in a somewhat different way, more than a quarter century ago. It worked there because of an enforcement system that works well. However, in the case of Brazil, the control system is considerably less effective. Thus it is very likely that there will be continued capital inflows, but in a much more chaotic way, and with winners and losers that were not intended when the measure was put in place. Brazil would be much better off if it were to liberalize its trade and capital transactions. In this way, there would be no distortions, and the currency would not appreciate so much. In the end, the world will need to accept the fact that the U.S. dollar is reflecting the significant adjustment in the country's economy. Unfortunately, countries like Brazil and China are not helping to attain a smooth process of adjustment worldwide.
Emy Shayo, Brazil equity strategist at JPMorgan in Sao Paulo: The Brazilian tax was widely publicized as a move to contain the real's appreciation, but the objective was also to deflate the asset price inflation that was forming in recent weeks. Flows in Brazilian equities have accelerated tremendously, partly due to a large volume of equity offerings and partly due to investors feeling comfortable with country's growth profile. Through the beginning of October, net foreign equity inflows this year amounted to $21 billion, while fixed income flows stood at $6 billion. The move to impose the 2 percent financial operations tax on equities (a first, considering that the tax in the past was only applicable to fixed income) and fixed income was a wake up call for investors that the market is not unidirectional. The measure should have a negligible effect on the country's economy both in the short and long term. It will not likely stem off portfolio investments, it will not lead to currency weakness and it won't make much of a difference in terms of tax collection. On the other hand, the downside is the reintroduction of regulatory uncertainty. Investors are now considering what other moves could take place if the currency continues to appreciate, or if there will be a shift on important pillars of economic policy, especially as the country is entering a pre-electoral period. The new tax brings residual benefits at best for Mexico and Colombia in terms of flows being diverted to those countries, as the investment theme in Brazil is different (and perhaps more compelling) of those for other countries in the region.
Republished with permission from the Inter-American Dialogue's daily Latin America Advisor newsletter.