US tax shake-up risks a dollar shortage and a global funding shock

8th December 2017
Resources Rising Stars

Congressional leaders in Washington are almost certain to clinch a sweeping deal on tax cuts and dollar repatriation by the end of the month, ushering in the most radical shake-up of the international financial system in modern times (writes Ambrose Evans-Pritchard in London’s Daily Telegraph).

The package likely to emerge from a blend of the House and Senate versions will slash corporation tax from 35pc to 20pc and double income tax thresholds. It amounts to $1.4 trillion (£1.04 trillion) of fiscal stimulus over the next decade, with "front-loaded" effects kicking in just as the US economy closes its post-Lehman output gap and the economy starts to overheat.

Simon Derrick from BNY Mellon said the timing of the Trump reforms may force the US Federal Reserve to jam on the brakes, inadvertently setting off a fresh surge in the US dollar. This could send a powerful impulse through the offshore global funding markets and squeeze vulnerable emerging economies such as Turkey, South Africa, or Brazil.

There will be a "tax holiday" for US corporations with an estimated $2.6 trillion of liquid assets held offshore, tempting them to repatriate funds at a special rate of 14pc. This could potentially turbo-charge any stampede into US dollars since this those who move first get a better exchange rate.

Mr Derrick said the gap in 10-year yields between US Treasuries and German Bunds – a key driver of the euro-dollar exchange rate – has widened to 205 basis points. This level would imply a 10pc dollar appreciation under normal trading circumstances.

Adam Posen, president of the Peterson Institute in Washington, said the Republican package is a “large unfunded tax cut” dressed up as reform, although it does sweep away a clutter of exemptions.

The net stimulus will be 0.8pc of GDP in 2018 and 0.9pc in 2019, coming at a terrible moment in the cycle when the economy is already steaming ahead. Growth in the fourth quarter is running at a rate of nearly 3pc. “We’re very close to full employment and there is going to be a boom, with a lot more inflation than people think. The Fed is behind the curve,” he said.

Mr Posen said the mix of measures could push the dollar to levels that would stun the markets, mimicking events in the mid-Eighties when a similar experiment of "loose fiscal/tight money" under the Reagan Administration led to a hyper-dollar and ballooning trade deficits. This is the exact opposite of what Mr Trump hopes to achieve and could cause him to turn trenchantly protectionist in two years’ time as the chickens come home to roost.

US companies keep excessive sums offshore because profits are not liable to US tax until brought home, hence the holdings of $257bn for Apple, $126bn for Google, $84bn for Microsoft, and $68bn for Cisco.

Technology companies keep most offshore funds in dollars. The great unknown is how much is held in euros, pounds, yen, or yuan by other firms. Goldman Sachs estimates that 20pc of the $2.6 trillion total is in foreign exchange. The Congressional Research Service thinks it is 54pc.

A survey of 300 companies by Bank of America suggested that 40pc may be in foreign currencies. Most said they had no intention of investing any money they bring home – as President Trump hopes – preferring to spend it paying down debt (65pc), buying back their own shares (46pc), or launching M&A bids (42pc).

World finance is highly sensitive to dollar shifts. The Bank for International Settlements says offshore dollar funding has soared to $10.7 trillion. A further $14 trillion of global dollar debt is hidden in derivatives and swap contracts that are “functionally equivalent to borrowing and lending in the cash market".

This $25 trillion total is unprecedented in the history of global finance. The BIS warns that rising US rates will tighten global conditions, both through a dollar squeeze and also by pushing up the benchmark price of world borrowing. This is set against a backdrop where debt ratios are at record highs and the Fed is reversing quantitative easing.

Dollar repatriation could lead to a global funding shock even if the money is already held in US currency. At the moment, overseas dollar holdings are made available to money markets for short-term corporate lending. Mr Posen said that if the funds return to the US this will drain offshore credit markets, even as it loosens funding markets in the US itself.

This has the makings of a self-reinforcing "feedback loop" since the Fed would have to raise rates faster, setting off an emerging markets storm and a sell-off in global assets. Sooner or later the whole process would short-circuit. The Fed would back off again – as it did in early 2016, to help the Chinese at a delicate moment – and dollar pressures would subside.

Nobody really knows what the effects of all these complex variables might be. James Knightley from ING said the Trump plan should be taken with a pinch of salt. While the headline cut in corporate taxes from 35pc to 20pc looks dramatic, most pay just 26-28pc after deductions. The Institute of Taxation and Economic Policy said the average for the last eight years has been 21pc.

Steve Blitz from TS Lombard said there will not be enough fiscal stimulus to move the needle, and it is far from clear what the dollar will do given that Europe and Japan are both rebounding. Complex hedging practices in the derivatives markets suggest that the euro will strengthen against the dollar next year.

The tax holiday for US companies in 2005 did lead to a 15pc rise in the dollar index (DXY) over a fifteen month period but the circumstances were very different. Mr Blitz said it was a zero-tax holiday and it was only offered for a short window of time. The Republican package today is open-ended and entails a 14pc tax. It may be a damp squib.

Most analysts agree that the package ultimately evades the real challenges facing the US as the population ages and Social Security and Medicare entitlements are stretched to the limits. The tax cuts will be "temporary" since that is the only way to slip them through Capital Hill by simple majority.

The reform chips away at tax benefits over time but is not enough to prevent US debt levels breaching legal limits flagrantly in the 2020s. The endless saga of cliff-edge budget politics in Washington will continue. The US has become chronically incapable of living within its means.

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