The benefits to market participants of the existence of this market are obvious. Speculators can leverage and gain larger positions, and hedgers of long positions held either directly or implicitly in the form of options could short stock to cover their positions. Again, net short-term dollar foreign borrowing for domestic stock purchases takes the form of a gross outflow in the form of dollar denominated margin and a larger gross inflow in the form of a stock purchase by a foreign address.
Avoiding Capital Import Taxes or Controls
Taxes or outright bans on the acquisition by foreign addresses of domestic securities have emerged in recent years as a means of stemming capital inflows. They sometimes have been imposed differentially by maturity of asset and by type of asset. Often, such taxes have been successful in that they have placed a wedge between domestic and foreign yields on similar assets. They can be breached by the usual invoicing subterfuges, but market participants have also used financial engineering to circumvent the taxes. Specifically, suppose that an enforceable tax is placed uniformly on all forms of gross inflows. Then, any positive net inflow will incur the tax, but gross transactions will move offshore. As an example, instead of acquiring an equity position directly, a foreign investor will buy an offshore equity swap from a domestic resident who can hedge without a tax. If the domestic resident has a lower credit rating, an export of capital in the form of margin will be recorded. There will be no taxable inflow, but foreigners can take risk positions in domestic assets.
If the tax is differential across types of assets acquired from abroad, the net inflow will tend to take the form that incurs the lowest tax. Similarly, if differential controls are imposed allowing equity investment but limiting short term, fixed interest inflows, the flows will enter through the least restrictive door. The risk and maturity characteristics of the inflow can then be resculpted through offshore derivatives to a more desirable form. For instance, if equity investment is given a better treatment than short term fixed interest securities or bank deposits, the inflow will take the form of a stock acquisition together with an equity swap that converts it on net into a floating interest loan of foreign currency. Even the maturity of the loan can be adjusted with an attachment by the lender of a stringent margining provision that permits the offshore creditor to realize cash on call.
The Role of Derivatives in Crisis-Driven Capital Outflows
Where such markets exist, forward contracts are the speculator’s instrument of choice in implementing an attack on a currency, the beginning of a sudden outflow of capital. Positions in forward contracts can arise suddenly or be built up gradually in the expectation of an impending devaluation. Such derivatives serve merely to effect a crisis that is emerging from other causes. Other derivative products, already outstanding in large volumes, may reflect an environment in which such speculation may be successful and may even determine the dynamics of the currency and financial crisis that ensues.