Will US tax proposals lead to a dollar surge?

A proposal for a new levy on imports included in a Republican tax reform plan has set off a lobbying war in the US business community and raised fears of looming trade skirmishes. But economists have also begun focusing on another potentially worrying aspect: what it means for the global economy.

The inclusion of a "border adjustable" tax system in the proposal being pushed by house speaker Paul Ryan and other leading Republicans would, according to experts, amount to the biggest change in global taxation in almost a century.

If economic orthodoxy holds true – and whether it would is the subject of significant debate – it could also lead to the biggest surge in the dollar since the 1980s with potentially damaging consequences, particularly in emerging economies. Paired with rising US rates and a Federal Reserve determined not to let the US economy overheat that could present a shock to the global economy that economists at the International Monetary Fund (IMF) and other institutions have begun trying to quantify.

Imports

In a report released last week rating agency Moody’s said that a 20 per cent tax on imports could lead to an appreciation of as much as 25 per cent in the dollar. That would be the largest swing since the aftermath of the 1985 Plaza Accords between the US, Japan and major European economies.

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“A full 25 per cent appreciation of the US dollar in real terms and over a short period will be unprecedented,” Moody’s wrote.

Such a move would force internal adjustments in economies such as Saudi Arabia and Hong Kong that have currencies pegged or otherwise linked to the dollar, Moody’s said, and hit countries with high levels of US dollar-denominated debt such as Jamaica and Venezuela.

But it would also likely affect larger economies such as China and, more broadly, lead to a reconfiguring of global supply chains that would have consequences for export-dependent economies and trade around the world.

“It would put a lot of stress on many emerging market economies,” said Eswar Prasad, a former IMF economist who has written on the growing role of both the dollar and China’s renminbi in the global economy.

In the case of China, a significant appreciation in the dollar “really drives them into a corner”, he said.

Policymakers in Beijing have increasingly been managing the renminbi against a basket of currencies rather than only the dollar. But the greenback's role remains strong and the bilateral rate politically sensitive with US President Donald Trump having accused China of being the "grand champion" of currency manipulation.

Were the dollar to appreciate sharply, prompting China to respond by propping up its own currency – as it has for the past two years – it would hurt its own position with other trading partners, Mr Prasad said. Roughly 80 per cent of China’s exports go to countries other than the US.

The good news is that Mr Prasad and others argue that emerging economies are in a much better position than they were in the 1990s when many were driven into crisis in large part due to heavy loads of dollar-denominated debt.

The economics behind expectations that a US border tax would lead to a big appreciation in the dollar also remain largely untested.

Reform

Advocates argue the tax reform in the short term would lead to more demand for US exports and dollars and slowing demand for imports and other currencies. It also would encourage more long-term foreign direct investment in the US and thus demand for dollars.

Wilbur Ross, the US commerce secretary, has backed the border tax idea in the past. But in an interview on Friday he made clear that he was not convinced currency markets would react as predicted. "I'm a little sceptical about the theory that there's somehow a totally free lunch and that the markets will exactly absorb everything," he told CNBC.

Sceptics also point out that US trade flows play a relatively small role in currency markets. The US’s total trade in goods and services was worth $5 trillion for all of 2016, according to official US data – equivalent to an average day’s turnover in global foreign exchange markets.

Hung Tran, a former senior IMF economist now at the Institute of International Finance, said he believed that partly because of this the adjustment to the dollar due to any tax changes would be “more moderate and more gradual than expected”. But such a change was also likely to come alongside rising US rates and fiscal stimulus, either of which would on their own boost the dollar.

- Copyright The Financial Times Limited 2017