APEC Finance Ministers Discuss Taxes and Capital Flows
"A lot of economies provided their experiences and there was good discussion," says Chee Sung Lee, assistant director of the Regional Office for Asia and the Pacific at the International Monetary Fund in Tokyo. "Discussions were focused on how economies can learn from each other's experiences and channels for providing mutual help through technical assistance." Freer movement of capital has been a recurring theme in the APEC Finance Ministers Process and policies and reforms to facilitate capital flows in APEC economies have been addressed at APEC Finance Ministers' Meetings since 1994.
Discussions at the Finance Ministers' Technical Working Group (FMTWG) encompassed how recent changes in financial markets, in particular how the growth of institutional investors (collective investment vehicles such as pension funds, mutual funds and hedge funds) affect capital markets. The changes also have an impact on financial market liberalization, reform sequencing and market supervision.
Participants at the meeting discussed financial institution reforms including removing barriers to entry while improving market resilience and efficiency (well-designed credit bureaus, interbank markets, information disclosure, collateral rights, foreign participation and ownership and impact of institutional investors). Privatizing state-owned financial institutions and implementing legal frameworks, as well as trade and investment agreements, were also key topics of discussion.
Strengthening regulatory environments, providing clear, consistent consequences for violations of laws and regulations and regimes for the winding up of financial institutions are all critical. Accountability to regulators and prudential regulations in the form of training financial regulators were also discussed.
"You need proper legal systems, proper accounting systems, all the basic institutional and governance systems, and all this need to be sequenced appropriately and thus may require some time to put in place," says Lee. "Each economy has to come up with the right legal, accounting and governing frameworks appropriate to the economy but consistent with international standards. Needless to say, countries must also have the ability to enforce them and that requires a lot of financial and human-capital investment. Obviously that can't happen from one day to another or even from one year to another."
Nguyen Thanh Long, an expert in the State Security Commission of Viet Nam's Finance Ministry, agrees with Lee's assessment. But he adds that there is standard thinking on financial sector reform: "It's pretty nice that all the delegates have now kind of converged their ideas and thinking," he says.
The key message is the importance of the liberalization of markets both to attract capital flows and to provide a more efficient way to channel savings, both domestic and foreign, and efficiently allocate investment. Reducing transaction costs and better risk sharing are critical. And diversification is key for this efficiency to attract and absorb more stable capital flows.
"A freer and more flexible environment in terms of cross-border capital flows and foreign-exchange-rate regimes will be the critical issue for attracting foreign capital flow," notes Hsi-Ho Huang, section chief of the Department of International Affairs in Chinese Taipei's Financial Supervisory Commission. "Corporate governance, accounting and auditing, transparency, information disclosure and proper protection for investors should be strengthened if an economy wants to attract more foreign investment."
Stefano Curto of the World Bank's Poverty Reduction and Economic Management Vice Presidency and a presenter at the meetings noted in a telephone interview from Washington that there are three characteristics that a financial sector needs to have, both for long-term development and short-term stability. "First, it needs to be robust in terms of risk taking. Secondly it needs to be transparent, and third it needs to be liquid."
Why are those characteristics so important? Obviously banks in the first stage of development are critical but, when an economy develops, banks are relatively inefficient to channel large amounts of capital flows. When an economy wants large capital flows it needs to diversify this market. To do so, it needs to provide transparent, reliable, timely, and meaningful information because the opportunity costs of information disclosure and the need for financial infrastructure, accounting rules, and legal arrangements for protection or payment systems increase with the level of sophistication of financial markets and diversification, Curto explains.
The recent World Bank report "East Asia Finance: The Road to Robust Markets" released at a conference in Hong Kong with the Hong Kong Monetary Authority on June 22-23 shows that, despite the increasing role of debt and equity, the vast majority of economies in APEC still heavily rely on bank intermediation, and with the exception of Singapore and Hong Kong, China, the banking sector as a whole in Asia accounts for about 50% of all financial assets, down from 62% in 1997.
It's really in the bond market that the region appears to be lagging. Most Asian economies are in line with international benchmarks (equity ratios) in terms of appropriate equity markets. But many economies in the region have under-developed bond markets. There are several initiatives underway at the economy and regional level to correct that, such as the development of the regional Asian bond markets. These initiatives are seen as an instrument to reduce the reliance on bank intermediation and at the same time enable access to long-term and stable financing, particularly in local currencies. The lack of diversification was one of the factors influencing stability during the financial crisis.
However, even if economies choose to move forward on regional bond markets, notes Curto of the World Bank, the actions to be taken are still largely at the country level. And while many of the regional initiatives have concentrated on the supply side of the equation, developing an institutional investor base is critical too, both to develop and to sustain a well diversified and resilient-to-crisis market, Curto explains. "At the end of the day you really need investors that buy and sell whatever activities are sold in the market to make a market liquid and sustainable," he says. The investor base is still relatively small in the region. Only Hong Kong, China and Singapore have a well-diversified investor base. This is still an area that economies need to focus on in order to strengthen demand. Says Curto: "It's still an important priority for the region, even though growing per capita income will eventually enhance the investor base in the future."
Beyond that, the underpinnings of sound financial sector reform involve a solid legal framework, including for insolvency, good corporate governance, as well as sound accounting and auditing systems. "These are really the fundamentals of a market economy and of a robust financial market," Curto says. "The effective governance and operation of the regulator and the regulated really depends on the broader legal framework."
Good corporate governance systems and sound accounting and auditing must also be in place. They are of critical importance in the context of information infrastructure by providing more meaningful disclosure of financial information. Explains Curto: "Enforcing them in a company or financial institution helps to ensure a fair and transparent return of investment and protects the capital of the foreign investor, providing the basis to attract larger and more stable capital flows."
Perhaps Huang of Chinese Taipei's Financial Supervisory Commission offers his APEC colleagues the best advice: "First, don't worry about opening financial markets for foreign players. Our experience shows that it will upgrade local financial markets since foreign players will bring in cutting-edge know-how in terms of operational procedures and product innovation. Second, adopting international standards and best practices will convince foreign investors to invest in local capital market and enterprises. And third, strengthening interaction between financial authorities and major international financial groups, as well as with foreign bankers, is very important for attracting foreign investment."
Discussions at the Finance Ministers' Technical Working Group meeting on the second theme of tax systems were equally fruitful. Middle and high-income economies have on average managed to replace declining trade tax revenues by increasing revenue from domestic taxes, hence keeping the total tax/GDP ratio unchanged or even increasing.
Low-income economies on the other hand, appear to have been less successful in this respect. Some economies continue to rely quite heavily on tariffs as a source of government revenue and trade tax revenues continue to be an important source of revenue in the Asia-Pacific region. On average, trade tax revenues still account for roughly 20% of all tax revenue. But with a view towards eliminating tariffs by 2020, as agreed in Bogor, Indonesia by APEC Economic Leaders in 1998, economies will have to find other sources of income.
It's difficult to say how long and how fast it will take economies in APEC to reduce that percentage. "It really depends on each economy because different economies have different reliance on trade taxes, and different economies have different elasticities within which tax reform to replace revenue may be undertaken," explains Lee. "There is no one size fits all answer so each economy will have to undertake specific analysis and studies that would include simulations on the pace and extent of policies linked to trade and tax reform measures. It is important to note that the focus should not only be on when they [trade tax revenues] have to come down to a certain level, since there is some flexibility on that. The focus should really be on what will be the long-term benefit from trade liberalization for the economy and the region and its contribution to modernizing the structure of economies."
Strengthening revenue systems means making sure the tax system is equitable and that it doesn't impinge on initiatives or production or competition. "Obviously there is a trade-off between trade reform and the desire to collect tax revenues," adds Lee. "But there is also recognition that over time, the reduction in trade taxes can be replaced by other taxes which together with improvements in the growth potential of economies because of the liberalization of trade would serve to sustain an appropriate of fiscal expenditures. However, the sources of taxes from trade as a percentage of total tax revenues will fall over time. That's inevitable."
Economies in APEC that have lowered their trade taxes as a percentage of their overall revenue can share their experiences with those that are in the process of implementing such measures. Those that have progressively lowered trade taxes have shown that you can't do it in isolation, you have to be prepared for it and make sure other compensating economic and financial policies are consistently implemented. You must ensure you have mitigating programs to try to protect the people that will be negatively affected, especially industry that will suffer. Says Lee: "One of the ways that was suggested was that you could replace trade taxes with domestic consumption taxes to best preserve the efficiency gains from a cut in tariffs as well as to sustain the level of revenue collection. But there are challenges to be faced from this revenue replacement measures. It is also important to note that efforts and commitments to broaden the tax base need to be continuous and consistent."
For most economies, prudence requires that compensating revenue measures be adopted to offset any loss of trade tax revenues consequent upon trade liberalization. For this purpose, there is great conceptual merit in using domestic consumption taxes - both the excises on particular goods and general sales taxes (like VAT) to offset such losses. There is also merit in strengthening the regime for direct taxes, particularly income taxes. Thus trade liberalization may need to be purposively sequenced with domestic tax reforms.
The final report of the Finance Ministers' Technical Working Group meeting will be submitted to the Finance Ministers' Meeting in September 2006. Their goal: improving capital flows, investment and revenue systems. It is hoped the finance ministers will then be able to draft policy recommendations for liberalizing the financial sector and improving market supervision after discussion with the private sector. Says Lee, "When the finance ministers meet they will discuss the findings of the FMTWG and come up with understandings on what concrete policies are needed to carry these issues forward."