Neil Irwin’s column on the border-adjustment tax spurred an interesting debate. Irwin notes that a 25 percent rise in the dollar (or even a somewhat smaller rise) would have an impact outside the United States, as the dollar is a global currency.
Dean Baker and Jared Bernstein note that the dollar moves around a lot without destroying the global economy. The projected moves in the dollar are no larger than the dollar’s 20 percent or so move over the last three years. Baker: “Movements of this size happen all the time. They certainly can cause problems, but the financial system generally deals with it.”
I still worry though. There is a difference between a 20 percent move (off a long-term low) and a 30 or 40 percent move. And there is a difference between normal exchange rate volatility and large, sustained currency shifts. I would note that the 20 percent rise in the dollar in late 2014 and early 2015 contributed to the change in China’s currency regime—and China’s shift to managing against a basket roiled global markets from August 2015 to February 2016. The world survived, but it wasn’t totally smooth.
Let me focus on two specific reasons for concern:
One. Balance sheet mismatches in emerging economies.**
Two. Dollar pegs, or basket pegs heavily weighted to the dollar.
One. Balance sheet mismatches. These are the old bane of emerging economies. Countries over-borrow in foreign currency. Their currency depreciates. And the country cannot pay its debts back. This was a big part of the story of the Asian crisis. And of subsequent defaults in Ecuador, Russia, and Argentina.
But things have changed since the 1990s.
The governments of most large emerging economies have more foreign currency assets than foreign currency debts. Central bank foreign exchange reserves exceed foreign currency bonds issued by the government.
This is the case in China’s central government—it has $3 trillion in foreign currency reserves and almost no foreign currency denominated bonds. And the governments of Brazil, Russia and India all also have more foreign currency reserves than foreign currency debt. The Saudis have issued a lot of dollar debt recently. But the Saudi government is still net long the dollar—foreign currency bonds are $17.5 billion (plus some loans), reserves are still $536 billion. The governments of big emerging markets are generally not big borrowers in dollars anymore. Even those with current account deficits.
There are some (partial) exceptions. Turkey is an interesting case, though the government of Turkey has only a modest amount of foreign currency debt (roughly $30 billion). But it is close because Turkey really has very few reserves. Around $55 billion of the central banks $106 billion in reserves (foreign currency and gold) have in effect been borrowed from the banks (see Paul McNamara; or the footnotes in Turkey’s SDDS reserves disclosure), and thus aren’t a hedge for the government. Argentina too after its recent bond issue.
Yet, in broad terms, emerging market governments are better positioned to withstand big foreign currency moves than in the past. (On the flip side, foreign investors have taken on more local currency risk—they are the ones who stand to lose.)
As many have noted, the FX risks within emerging markets now largely lie on the corporate side. Emerging market firms stepped up their dollar borrowing even as emerging market governments stepped down. I wouldn’t assume that just because firms were able to withstand a twenty percent move in the dollar they can easily withstand a forty percent move—especially if U.S. rates move up. The actual risk though likely varies. A lot of the biggest emerging market corporate issuers of dollar denominated bonds likely have state backing—PEMEX ($100 billion in debt, not all in dollars), Petrobras (over $100 billion in debt), Rosneft, Gazprom, the Chinese state banks, the big Chinese airlines, and the like. And most of these countries hold enough reserves to cover the foreign currency debts of their big state companies as well as the direct foreign currency debts of the state. But that doesn’t mean that a further rise in the debt burden of state companies wouldn’t be painful.
Those most exposed are countries where there are big, broader foreign currency mismatches throughout the corporate sector. Turkey for example. Any rise in the dollar effectively shifts wealth from Turkey’s firms to Turkey’s households—at least those with dollar deposits.*** At some point the strain will become too big, and the banks will have to restructure their corporate loan book and absorb losses. Turkey’s banks are already hurting from a decline in the lira, which reduces their equity buffers (the banks have big foreign currency balance sheets, but keep their equity in lira—so the equity base shrinks relative to their total liabilities as the currency weakens).
And there are a set of countries and companies that are exposed not so much to the dollar’s value relative to other large exporters of manufactures (Japan, China, Korea and Europe) but to the dollar price of commodities. That though is a subject for another time. The impact of the border adjustment on global commodity prices (notably oil) is a hotly debated topic, and I am not convinced that it will be as mechanical as some have argued.
The other risk comes from the world’s remaining dollar pegs. A stronger dollar pulls up the value of a lot of other currencies, as many countries still peg to the dollar — even though a reasonable number of de facto dollar pegs have either broken or transformed into basket pegs over the last two and a half years (the Kazakh tenge for example, or the Nigerian naira)
I will set aside the questions around the Saudi peg. A stronger real effective riyal would hinder the Saudis’ efforts to diversify their economy away from oil, but I never took those efforts all that seriously. What really matters for Saudi Arabia in my view is not so much the value of the dollar against the G-3, but the value of oil in Saudi riyals. Dollar/oil matters more than dollar/yen—or put differently, dollar/yen only matters to the extent it changes dollar/oil.
The hardest questions involve China. It doesn’t float now. And strictly speaking it doesn’t manage its currency against the dollar. Rather it tightly manages its currency against a basket. China would have to decide how it wants to react to a border adjustment. It won’t happen automatically. And it is easy to see how this could be an important source of future instability.
Consider the following. China could decide to maintain a basket peg, and thus let the renminbi adjust to the border adjustment in proportion to the global market adjustment (and specifically moves in the dollar/euro and dollar/Asia). Because of the weight of the dollar, the Hong Kong dollar and the Saudi riyal in China’s basket, the renminbi would move by say 2/3rds as much as the dollar moves against the major advanced economies (Mexico and China dominate the dollar basket versus emerging markets—and neither enters into China’s own basket—China for obvious reasons and Mexico because direct trade is limited). So if the dollar appreciated by about 15 percent against the majors, the mechanical operation of the basket would produce a roughly 10 percent appreciation in the renminbi against the dollar.
That would offset less than half the border adjustment on China’s exports (a full offset of a 20 percent border-adjustment on imports, given the math, requires a 25 percent move). And other countries would also gain relative to China, as their currencies would depreciate more.
Would the market—which in China, is primarily domestic institutions that can move funds across the border more easily than international investors—believe that China wouldn’t move by more? Or would it start to speculate that China ultimately would want a full adjustment? Would China’s controls be effective if domestic exporters and importers believed that a further depreciation was imminent?
And if China did a full adjustment—a one off reset of the level of the basket—how would other currencies respond? Would China trigger even bigger depreciations elsewhere in Asia?
It doesn’t seem to me all that hard to see how there is an overshoot in Asia, given the large role that China plays in Asian trade.
I know that goes against the conventional wisdom that the border adjustment won’t be perfectly offset because capital flows exceed trade flows, which is true, but incomplete—as it doesn’t quite capture the dynamics around America’s largest single source of imported goods and the biggest single contributor to the dollar’s trade-weighted index. China’s currency is heavily influenced by trade flows, including financial outflows disguised as trade flows—and of course by expectations about the yuan’s future course against the dollar. Those would be destabilized by a border adjustment.
China doesn’t have giant domestic foreign currency mismatches. There are a few (the airlines) but they are manageable in the big scheme of things. The risk to China comes from the potential impact of outflows (and the policies introduced to stem outflows) on domestic financial stability. And the risk to the world in turns comes from the trade impact from a complete break in China’s peg and a major depreciation of the renminbi. One that overwhelms any border adjustment.
* Small aside on the border adjustment: a border adjustment eliminates the incentive to game the system by shifting profits offshore, but it does so by exempting profits on exports from any onshore tax. It basically abandons the notion of trying to tax the intellectual property (IP) rents on export income, or the economic rents from the export of natural resources for that matter. And it could create incentives for other kinds of gaming. I am convinced that the current system is heavily gamed in ways that hurt U.S. exports of IP and high-margin products (the active ingredient in pharmaceuticals for example), but the proposed border-adjustment gets rid of some of the games by in effect not taxing certain kinds of hard-to-tax income.
** I am assuming that large financial institutions in the advanced economies have matched books (whether directly, or through cross-currency swaps and similar hedges), and thus do not have any worrying balance sheet mismatches. That is also just an assumption. At the same time, the moves in the dollar/euro and dollar/yen have put balance sheets to test.
*** Turkey’s central bank publishes data on the foreign currency book of its corporate sector. Others should too.