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The FX Implications of a Border Adjustment Tax

There has been a lot of talk about the possibility of the Trump administration introducing some form of border tax. The result thus far has been a variety of proposals and a general lack of clarity. Trump has presented it as a way of restoring jobs to America and at the same time helping to pay for building the wall with Mexico, and has suggested a 20% tax on Mexican imports. However, this simple tariff increase is not the preference of the Congressional Republicans. They prefer the idea of a border adjustment tax, which currently looks the more likely option. The proposal on the table is a tax border adjustment of 20% combined with a corporate tax cut to 20%.

Despite the early stages and complexities of the proposed tax, the following provides an overview of the border tax and potential implications for the currency markets:
•Border tax adjustment or import tariff?
•Potential FX impact of border tax adjustment
•Individual currency impacts – EUR, GBP, CAD, MXN
•Appendix – the details of a border tax

Border tax adjustment or import tariff? What is the difference? •A standard tariff is a tax applied to imported products. That’s simple enough.
•A border tax adjustment is more complex. It includes an import tax, but also an effective export subsidy, as well as some other things. For a more detailed description, see the appendix below.

Potential FX impact of border tax adjustment
Three reasons the border tax plan is USD positive: 1.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).
2.It is likely to encourage current investment by increasing the immediate tax write off available for capital expenditure, thus boosting growth and interest rates.
3.The plan will include provision for the repatriation of US corporate earnings held overseas to avoid the current high level of US corporate tax. This repatriation could have both direct implications for the USD, because some is held in foreign currency, and indirect, as the repatriated funds may also be used to boost domestic investment.
Academic economists generally see the border tax adjustment as likely to boost the USD by as much as 20% – 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% to offset the tax, leaving everything else effectively unchanged.
While this is too simplistic, 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 Caveats
The first problem for the dollar bull argument is that FX markets often do not immediately react to expectations of trade effects, and in many cases trade is not the dominant determinant of FX rates in the short to medium term. The border tax would create a structural change in the US trading relations with the rest of the world, which should be significant for the equilibrium level of the USD in the long run. However, in the short run such structural issues may well be dominated by cyclical factors, typically relative interest rate levels.

Foreign exchange prices are determined by a multitude of trade and capital transactions which equalize the current and financial accounts. In other words, the exchange rate adjusts to the trade balance and the demand for US and foreign assets to ensure that the trade deficit is exactly funded by foreign capital inflows. But the fastest and largest moving part of this balance is capital flows, not trade flows. Small changes in relative interest rates can quickly move capital flows and the dollar, and while trade flows matter in the long run, they don’t tend to be the key driver in the short run. Of course, the initial announcement of a border tax adjustment would no doubt trigger initial dollar gains as markets anticipate the implied improvement in the trade balance, or the alternative of a USD rise to offset it. But since it takes time for trade flows to react to any change in prices, the actual trade impact would take a lot longer. Estimates vary but a devaluation is generally not expected to have its full impact on trade for at least 3 years, and that holds for any general change in import and export prices.

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, so some of the impact will be felt in foreign companies’ profits rather than trade volumes. So the direct impact from trade prices and volumes 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 will nevertheless trigger some USD reaction.

However, other aspects of the proposed tax reform could also have a significant impact. The proposed GOP cut in corporate tax to 20% from 35% would be seen as stimulative for investment and the economy, leading to higher interest rates and a higher USD. The tax reform is also expected to include provisions to allow the repatriation of profits currently being held abroad to avoid US corporate tax. Estimates suggests these amounts are huge – upwards of $1.5trn – and although clearly not all of this would be repatriated and a large chunk is also already held in USD, there is certainly likely to be some positive impact on the USD.

One other caveat is the possibility of retaliation and problems with non-compliance with WTO rules. Technically, the border tax adjustment would be seen as a breach of WTO rules because the US does not have a direct consumption based tax system – such as VAT – but an indirect income tax system, and this is not considered consistent with border tax adjustment. While the point is technical and to some extent debatable, the WTO is likely to see the reform as a breach, especially inasmuch as it allows the deduction of labor costs (unlike VAT based systems). Nevertheless, it isn’t clear that this will stop the reform being passed, or even that sanctions or retaliation would be seen quickly (or even at all). In practice, we suspect the WTO will not prove a significant stumbling block.

There is a lot of uncertainty about the timing of any tax reform, but it still seems 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. While some are still skeptical that it will be passed, latest talk from Washington suggests broad agreement has been reached and the bill could be passed by September or October, and be implemented in the 2018 tax year. However, it may be that nothing is implemented until 2019.

Individual currency impacts
Bearing in mind that the border tax (or import tariff) is unlikely to be implemented until 2018 at the earliest, the scope for USD impact this year is limited, though there will certainly be some announcement effects. Individually, currencies will be affected depending on their exposure to the US market, the importance of trade as a proportion of the economy and the currency sensitivity to trade flows relative to capital flows.

The impact on the EUR seems unlikely to be large, but there may be a modest effect. EUR/USD is a currency market with huge volume, most of it related to financial account transactions rather than trade. While the relative trade balances and current account positions of the US and the Eurozone are important for the valuation of EUR/USD in the long run, it is instructive that the EUR has been declining in recent years while the Eurozone current account has been improving. The EUR is already at quite low levels relative to long term equilibrium measures despite a very substantial current account surplus, primarily because of a rising yield differential between the US and Europe as the US economy has outperformed in recent years.

Nevertheless, the Eurozone does have a very substantial trade relationship with the US, and runs a very significant trade surplus. Much of this is due to manufactured goods which may be most affected by a border tax because there is a relatively high consumer sensitivity to price in these goods. So the introduction of a border tax (or import tariff) could be expected to have a noticeable impact on the US bilateral trade balance with the Eurozone unless there was a significant EUR/USD adjustment. But because EUR/USD is largely determined by financial rather than trade flows, because the EUR is already at low levels, and because any trade effects will take quite some time to be felt even after any new policy is introduced in 2018 or 2019, we would not expect any major EUR/USD impact. A greater impact could come from repatriation of funds held by US companies in euros, but as with other aspects of the tax reform, this will not happen until 2018 at the earliest.

For 2017, the impact on EUR/USD is most likely to come from any announcement effect on US yields related to the tax reform proposals. The market response will be tangled up with other policy proposals such as infrastructure spending plans. However, if there is a reaction it is likely to be favorable to the USD if the market perceives fiscal plans are likely to prove positive for the economy – particularly if the market believes the Fed is likely to respond with a more rapid pace of increase in interest rates

As with EUR/USD, in the short to medium term GBP/USD tends to be more determined by financial flows and speculation than trade flows, and as such the border tax would probably not normally have a huge impact. However, the current UK situation is quite special, because the recent UK decision to leave the EU means the UK is particularly sensitive to any trade issues given the concerns about the probable loss of access to the European single market. There has been some hope within the UK that some loss of export markets in the EU could be offset by greater access to the US under a friendly Trump administration. But analysis suggests that the UK trade relations may be among the most sensitive to a border tax, as the composition of UK/US trade is particularly price sensitive.
Once again, nothing tangible is likely to happen on the trade front until well into 2018, but the concerns about Brexit show that these issues, even if a long way in the future, can have substantial FX impact in the present if they are expected to have a major economic impact. Given the climate, GBP/USD may prove more sensitive to worries about the impact of a border tax than it might have at other times, and GBP/USD could be expected to fall on the announcement. Magnitudes are very hard to assess, and we would not expect anything like the 20% move in the USD that some suggest will result. However, GBP/USD could potentially fall 5% or more if the market becomes concerned about the impact on UK trade. Of course, with the UK expected to trigger Article 50 at the end of March trade issues will be front and center, and whether any border tax announcement has an impact may depend on where we start from.

USD/CAD looks likely to be the most vulnerable currency pair to a border tax. Most of what can be said about Canada can also be said about Mexico, but the main difference is that USD/MXN has already moved substantially in response to threats of a border tax/import tariff, while USD/CAD has so far been largely unaffected.
The US is by far Canada’s biggest trading partner, taking 75% of Canada’s exports. Exports to the US are worth around 20% of Canada’s GDP. Thus a 20% import tariff or border adjustment tax would have a huge impact on Canada, even though Canada’s exports to the US tend to be comparatively price inelastic. The trade balance is a more important factor for USD/CAD than EUR/USD or GBP/USD, but because of the scale of US/Canada trade, the impact of a border tax on the Canadian economy would also have big indirect effects via interest rate expectations and consequently financial flows. It is of course hard to anticipate the timing of any market reaction, but the announcement of the imposition of a 20% border tax or import tariff could be expected to have a very significant impact on USD/CAD. From trading close to 1.30 currently, a quick move to near 1.40 would seem likely, and in the longer run could lead to an equilibrium near 1.50.

Much the same can be said about Mexico as can be said about Canada. The US is by far its biggest trading partner, and exports to the US represent more than 20% or Mexican GDP. But the key difference in the likely currency impact is that USD/MXN has already moved substantially in response to concerns about US tariffs and other Trump related concerns. While USD/CAD has fallen since the beginning of 2016, USD/MXN has risen around 13%, and since the beginning of 2015 USD/CAD is up around 10% while USD/MXN is up more than 60%. Both currencies have been affected by the oil price over the period, but in recent times USD/MXN has been vastly more affected by Trump protectionist rhetoric than USD/CAD.
Now, it is possible that a new import tariff could be focused on Mexico, but this looks increasingly unlikely. The generalized tax reform proposed by the GOP would mean the border tax adjustment applied to all imports and exports, whatever the origin or destination. If this is the case it may be that USD/MXN has already seen the majority of its reaction, and other currencies – particularly the CAD – are more vulnerable. Having said this, the inherently higher volatility of USD/MXN and its status as the barometer of US trade relations may mean it is very sensitive to the announcement of any border tax plan. But we suspect that it will outperform the CAD after any initial reaction.

Appendix – the details of a border tax
In the US system, currently a company is taxed on its profits regardless of where they are earned. The Congressional Republican proposal includes a border tax adjustment as part of a general tax reform which switches the US tax system from the current “worldwide” tax system to a “territorial” tax system. In a territorial tax system companies are only taxed on goods and services consumed domestically. Normally, such a system is based on consumption taxes, like VAT, which companies pay on all their sales. But if they export their production they get a rebate of the VAT because they are not selling the goods domestically. Also, imported goods incur a tax so there is a level playing field with domestically produced goods which incur VAT.

The US case is slightly unusual because there is no VAT, but tax is levied on corporate revenues minus expenses. But to put domestic and foreign producers on the same footing in this system, Congress argue a border adjustment tax is necessary because otherwise foreign producers are at an advantage in US markets because they are not taxed by the US. Meanwhile, US exporters don’t pay tax on export revenues because they are not producing goods consumed in the US.

In practice, this looks like an import tariff, but it is also an export subsidy compared to the current situation, because US companies won’t pay tax on exports.

In addition, corporations would not only be able to expense their investments, but also to deduct their wage bill (and some charge for land use). The idea is that we are already paying taxes on wages in through payroll taxes and worker’s income taxes, and it doesn’t make sense to tax wages once more. This effectively provides a subsidy to domestic labor.

Importantly, a border tax adjustment isn’t a border adjustment if it isn’t adjusting for a specific approach to domestic taxation. Nor is a border tax adjustment applied to a single country. In fact, if it isn’t adjusting for domestic tax rules, it looks a lot like a tariff, and, like a tariff, it would run counter to US trade commitments and would therefore likely generate trade retaliation. Because the US tax regime is not consumption tax based, the WTO is likely to see a border tax adjustment as a breach of WTO rules. The alternative of a simple tariff on imports has the benefit of being simple, but is very clearly against WTO rules, and wouldn’t provide the politically advantageous benefit to exporters. It is possible it happens but looks the less likely option. Nevertheless, both approaches mean higher prices for imports.

Compliments of Bannockburn Global Forex, LLC – a member of the EACCNY