Will China impose a punitive tax on forex trades?

At a time when, Chinese currency Yuan seems to be stabilizing in the foreign exchange (forex) market, the indications from the government about imposing a Tobin tax, a punitive levy, on forex transactions aimed at reducing trading in currency. After the unexpected devaluation of Yuan by 1.9 percent on 11 August, the Chinese currency fell further and recently started coming back into stabilization mode.

The latest indication of punitive tax in an article published in China Finance, an official magazine of People's Bank of China (PBOC) is expected to weaken the business confidence. It could also result in capital outflows as well, caution forex analysts.

Yi Gang in his article 'Direction for the Reforms and liberalization of Foreign Exchange Management' in China Finance suggested Chinese government to impose a punitive tax on forex trades and handling fees to reduce the trading volume in Yuan. The call by a deputy governor at China's Central Bank in the official magazine is considered to be a serious issue in the forex market.

Yi Gang one year ago proposed Tobin tax when Yuan was strong. Whereas now the Chinese currency is weaker in the forex market and the current situation holds value for his suggestion. Yuan was devalued by 1.9 percent on 11 August and further dropped by 2.9 percent in the forex market. It started stabilizing in September and rebounded 0.5 percent so far.

The Chinese government is concerned about the possible capital outflow following the economy slowdown and possible US interest rate hike. Forex traders alert the Chinese government that frequent offloading of US dollar in support of Yuan will decrease the country's forex reserves. It'll also squeeze the liquidity in the onshore market, caution the traders.

Investors feel that the Yuan in real terms gone down further as official quotes are intentionally kept at high level. The Chinese government is making measures to show the world that Chinese markets are recovering. Zhou Xiaochuan, Governor, expressed his hope for the rebound in the Chinese markets as the correction after the continuous upsurge in the first half of 2015 was over.

Instead of eroding in forex reserves, China will definitely prefer imposition of a punitive tax to support Yuan in the forex market. One month ago, Chinese central bank asked financial institutions and banks to set aside a reserve for one year without any interest on that reserve. The reserves level was equivalent to 20percent of forward and swap contracts in Yuan and 10 percent of options in Chinese currency.

The drop in forex reserves during August was steepest since May 2012. The average of China's forex reserves was $778204.60mn during 1980-2015. It touched an all-time high of $3993212.71 in June 2014 and record low of $2262mn in December 1980.

The Chinese Central Bank was offloading US dollars to support falling Yuan. As a result, foreign exchange reserves were dropped by $93.9bn to $3.557 trillion in August. According to unofficial estimates, the drop would be $150bn in August alone. PBOC was offloading $20bn a day in support of Yuan. In support of its currency Yuan, the Chinese government used to enter onshore renminbi market. For the first time, the Chinese government is intervening in an offshore market to support Yuan.