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Heads up, yuan forex traders! The People’s Bank of China recently drafted a set of rules that could levy a Tobin tax on yuan positions. In doing so, the Chinese central bank could discourage speculative trading against the currency and keep volatility in check.

What in the world is a Tobin tax?

A Tobin tax, which was first proposed by economist James Tobin in 1972, is defined as one that is imposed on all spot conversions of one currency to another. He suggested this idea after the Bretton Woods system of monetary management ended in 1971, leading to the rise of the U.S. dollar as a reserve currency.

According to Tobin, this type of tax could promote international currency stability since it would cushion forex fluctuations from short-term speculative positioning. He suggested a low rate such as 0.5% to ensure that it won’t be large enough to be a barrier to international trade activity.

Haven’t Chinese officials done enough to curb yuan speculation?

forex yuan taxIt depends on who you ask. The PBOC appears to have pulled out all the stops to prevent speculative forex positioning against the yuan, from restricting the currency’s offshore supply to preventing mainland banks from moving yuan abroad. In addition, the Chinese government has also made efforts to narrow the yuan trading spread while state-run banks have intervened to support the currency.

How will this affect your forex trades?

Yuan forex positions would be more costly to open, which means that your trade would need to make more than the tax rate in order to end up being profitable. Also, having a tax on yuan transactions could wind up reducing liquidity and leverage for China’s forex market while giving the government greater control over its financial arena, which is already the case for its local stock exchanges. However, this policy might hurt the yuan’s chances of achieving its prized world reserve currency status, which is set to be granted by the International Monetary Fund this October.

Keep in mind that the hotshots over at the IMF would like to see less yuan devaluation efforts and a “freely usable” or easily convertible currency driven by good ol’ market supply and demand rather than government action. If a Tobin tax imposed on yuan forex trades leads the IMF to change its mind about including the Chinese currency in its SDR, huge capital outflows from China could be seen, possibly leading to another stock market slump.

For some market analysts such as Singapore-based foreign-exchange strategist and economist at Commonwealth Bank of Australia Andy Ji, this tax could wind up hurting market sentiment and spurring more panic among investors since it represents a step backwards in attaining better forex convertibility for the yuan.

But let’s not get ahead of ourselves. The PBOC’s Tobin tax proposal still needs approval from the central government and it may take a while before any new rules are implemented. Still, it’s worth noting that the yuan has been steadily depreciating since the news broke out earlier this month and after Chinese officials didn’t rule out using a Tobin tax to discourage currency speculation.