How the border tax may affect the U.S. dollar
INSIGHT ARTICLE |
In the March 10, 2017 issue of The Real Economy, Neil Brenner of Bannockburn Global Forex LLC, examines the implications of the proposed border adjustment tax on the U.S. dollar. The following is an excerpt from that issue. For more information, read the full edition of The Real Economy.
The possibility of the Trump administration introducing some form of border tax is one of the most discussed developments of the new presidency–and one of the most uncertain. The issue evolves on a near daily basis. Of the variety of proposals, the highest profile is Trump’s suggestion of a 20 percent tax on Mexican imports (to pay for the wall). However, this simple tariff is not the preference of the congressional Republicans. They prefer a border tax adjustment, which currently looks to be the most likely outcome. A proposal on the table is a border tax adjustment of 20 percent combined with a corporate tax cut to 20 percent. This would likely apply to imports from all countries—not just Mexico. A border tax adjustment is similar to but more complex than an import tariff. It includes an import tax, but also an effective export subsidy. Thus, it would make U.S. exporters much more competitive abroad, and domestic producers more competitive with imports.
Potential FX impact of border tax adjustment
The introduction of a border tax adjustment is positive for the U.S. dollar (USD) because it increases the price of imports and reduces the price of exports. Unless the USD rises, this will improve the trade balance (which itself will tend to push the USD higher). There are also other aspects of the tax reform plan that would be dollar supportive, like the provision for the repatriation of U.S. corporate earnings held overseas to avoid the current high level of U.S. corporate tax.
Academic economists generally see the border tax adjustment as likely to boost the USD by as much as 20 percent—the size of the proposed import tax and export subsidy. The simple argument is that if other things are equal the dollar will need to rise by 20 percent to offset the tax, leaving everything else effectively unchanged. This is too simplistic, but the bottom line is that the imposition of a border tax adjustment is very likely to be supportive for the USD.
The question is by how much, when and against what, and whether some of the adjustment has already happened.
The reason it isn’t quite that simple is the trade effects of price changes take a long time to be felt and the largest moving part of currency demand is usually capital flows, not trade flows. While trade flows matter in the end, they do not tend to be the key driver in the short run.
For example, the Euro will be subject to extreme volatility this year as the upcoming French elections in April and Greece’s ability to repay its maturing debt this summer will enhance political and economic uncertainty in Europe.
In addition, even in the long run when all the trade implications have been realized, the impact is likely to be smaller than the tax implies. Some of the tax is likely to be absorbed by foreign exporters. Therefore, the full impact could be quite slow in coming, and is unlikely to be as large as the academic estimates suggest, but the market’s anticipation of the impact should nevertheless trigger some immediate USD reaction.
While there is uncertainty about the timing of any tax reform, it is likely that the House Republicans will present their proposals within the first 100 days of the Trump administration—so broadly by the end of April. Latest talk from Washington suggests the bill could be passed by September or October, and be implemented in the 2018 tax year.
Individual currency impacts
Bearing in mind that the border tax is unlikely to be implemented until 2018 at the earliest, the scope for USD impact this year is limited. Individually, currencies will be affected depending on their exposure to the U.S. market, the importance of trade as a proportion of the economy, and the currency sensitivity to trade flows relative to capital flows. This means the countries with big trading reliance on the United States and small capital markets will feel the biggest impact. Canada and Mexico are prime examples. The Canadian dollar (CAD), in particular, looks vulnerable, because it has moved very little against the USD in the last couple of years, while we have already seen a big move in the USD and the Mexican peso. The impact on the more liquid European currencies is likely to be less dramatic, although the British pound (GBP) could be significantly affected because of the current concerns about UK trade post-Brexit. There could also be big impacts on the smaller Asian countries that are heavily dependent on exports to the United States.
Operating with continued uncertainty
The timing, legislative details, and therefore, implications of a border tax adjustment will remain uncertain in the short run. However, currency volatility could be significant and long lasting, particularly considering recent developments beyond U.S. borders.
Currency volatility can have a range of negative impacts on a business, ranging from margin pressure, to bank covenant violations, or even the viability of a business. Therefore, businesses need to both insulate themselves from inevitable short-term volatility while giving themselves time to address the competitive implications of longerterm trends. This can be accomplished through a proactive currency risk management program.
For instance, a 20 percent increase in the value of the USD could cause a range of outcomes for a U.S. exporter–from making its goods 20 percent more expensive to decreasing the margins of the business by 20 percent, or some combination of these outcomes.
An efficient method many businesses use to dampen or eliminate the effects of this variability is the use of currency forwards. A forward contract allows a company to lock in a certain future exchange rate for a specific currency amount for future delivery with no upfront costs.
As an example, a U.S. company exporting to Canada and selling in CAD can lock in the value of its future CAD receivables ahead of time, thereby reducing or eliminating its exposure to the potential volatility of USD/CAD in the interim period.
To accomplish this, a company could enter into a series of forwards monthly, for example, for 12 months into the future. This strategy is known as a rolling hedging program. As each month’s receivables is collected, a new forward is added so that the company is always hedged 12 months out. In this scenario, the company at all times has visibility into the USD value of its anticipated CAD receivables for 12 months into the future, and is therefore, not as exposed to the political and economic factors that will drive volatility in the USD/CAD relationship during that period. This then gives the business time to adjust to the changing competitive dynamics.
When evaluating risk, companies should take into account both recurring (such as import or export payments and receipts) and one-off transactions (such as foreign denominated capital expenditures or merger and acquisition activity).
Considering the range of variables each business faces, there is no such thing as a one-size-fits-all approach to managing currency risk. That being said, there are a number of strategies that can be deployed beyond the illustration above depending on the specific set of circumstances. With continued uncertainty expected in global markets, most businesses can’t afford to be exposed in this area.
Bannockburn Global Forex, LLC is a capital markets trading firm specializing in currency advisory and execution services for closely held businesses.