The introduction of a border tax adjustment (BTA) to the U.S. corporate tax code would be disruptive to currency markets, global trade, and global supply chains. Yet, although U.S. politicians have been discussing the idea for weeks, I have found little evidence that the market is currently discounting its implementation. In particular, several emerging markets stand to lose should the BTA be adopted, for a variety of reasons:
- Not all exchange rates float freely: Since emerging market currencies are unlikely to depreciate to fully offset the BTA rate, it would become a de-facto trade tariff. This has the potential to hurt not just Mexico but also other emerging economies with a large share of their exports going to the US. At the same time, the competitiveness of U.S. exports vis-à-vis those of emerging economies would increase. Taking into account both industry and destination competition factors, along with the relevance of trade to their economies, the BTA could negatively impact not only Mexico but also a number of open Asian economies including Taiwan, Malaysia, Thailand, South Korea, as well as some Eastern European countries like Czech Republic, Hungary and Poland.
- Prices of tradable goods are sticky and U.S. dollar-denominated: The vast majority of world trade is invoiced in only a handful of currencies, with the U.S. dollar being the most dominant. In addition, due to the existence of contracts and transaction costs, international prices in the currency of invoicing are quite insensitive to exchange rates in the short to medium term. This means that even in the hypothetical scenario where all world currencies adjust to fully offset the BTA, countries exporting to the U.S. would still be negatively affected due to the U.S. dollar denomination and stickiness of invoice pricing.
- Tighter global financial conditions: Given the U.S. dollar's central role in global finance, a surge in the value of the U.S. dollar as a result of BTA implementation would tighten global financial conditions for emerging markets. Overall weaker emerging market currencies would make it challenging for corporate issuers with large U.S. dollar debts and local-currency earnings to honor their obligations. Sovereigns with large external financing needs would also struggle. Given their large current-account deficits, Turkey, Colombia, and South Africa could come under pressure.
- Global supply chains and FDI disruptions: The BTA and other provisions of the U.S. tax plan under discussion provide an incentive for corporations to relocate production overseas back to the U.S. This would have an impact on globally integrated production lines and foreign direct investment (FDI) flows into emerging markets. In this regard, countries with a large share of U.S. FDI to GDP would suffer, including of course Mexico (around 20 percent), but also Hungary (around 10 percent) and Brazil and Thailand (both around 5 percent).
Since tax legislation needs U.S. Congressional approval, the process of reshaping the tax code is certain to take months, and the final legislation may not be approved until the end of the year or even early 2018. In addition, we do not yet expect it to be included in the approved version of the tax reform in the base case scenario.
What is clear, however, is that this U.S. policy initiative is worth monitoring and, if approved, is unlikely to be supportive of emerging market economies and assets, considering we find little evidence that the market is currently discounting its implementation.
Commentary by Alejo Czerwonko, emerging market strategist at UBS Wealth Management.
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