Here Is How The US Tax Reform Could Be A Boon For USD? - Morgan Stanley

Here Is How The US Tax Reform Could Be A Boon For USD? - Morgan Stanley

25 December 2016, 09:52
Vasilii Apostolidi

The House Republican Blueprint proposal to "border adjust" the corporate income tax would have a significant impact on FX markets.

If implemented, border adjustability would likely push the USD TWI 10-15% higher, but not fully offset the impact of the provision on importers and exporters.

Border Adjustability: The House Republican Blueprint proposes to convert the corporate income tax into a destination-based cash flow taxation system that would 'border adjust' by not taxing revenues from exports and disallowing deductions for the cost of imports. The economic effects of such a policy are similar to an export subsidy combined with an import tariff of equal size.

Exchange Rate Offset: In the absence of exchange rate changes, this policy would boost US exporters at the expense of importers. However, many economists theorize that the policy is trade neutral as the dollar should appreciate ~25% to offset the border adjustment: a 20% credit on exports and corresponding disallowance for imports.

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USD Appreciation But Not Full Offset: We don't expect a full exchange rate offset of the effects of border adjustment; the empirical breakdown of Purchasing Power Parity (both absolute and relative) in the short run, global supply chains and concerns about a World Trade Organization (WTO)-led response will limit full USD offset. However, we still believe USD can rally 1015% on a trade-weighted basis if border adjustment is implemented at the proposed 20% corporate tax rate.

Broad-based USD Appreciation: As the policy would apply to all imports and exports, USD appreciation would be broad-based. However, USD may outperform against countries which are more welcoming of currency depreciation and have few global supply linkages to the US, such as Japan, Korea and the Eurozone. We believe MXN would depreciate significantly but supply linkages and the central bank's response could limit depreciation. We expect the People's Bank of China (PBOC) would allow CNY depreciation but less than other currencies.

Political Pushback Already Occurring: Because of the large potential for disruption, it is possible the border adjustability plan will be dropped in favor of a plan without similar FX impacts. However, there is no guarantee and, at the very least, USD may be supported in the beginning of next year as the plan gets more visibility.

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