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Sunday, July 22, 2018

Uncertain new year

US election changed global financial calculations. Emerging markets must wait and watch.

Written by Jahangir Aziz | Published: December 22, 2016 3:09:37 am
Donald Trump, Trump, Trump electoral college, Trump electoral votes, US electoral college, US president-elect, US politics, world news, indian express President-elect Donald Trump. (AP Photo/Andrew Harnik)

It’s now been more than a month since the surprise election results in the US and there is little clarity still on the specific economic policies — domestic or external — the new administration might adopt. On the one hand, there is a set of policies that the new administration has planned to implement in its first 100 days in office, while on the other, there is uncertainty over which ones will be chosen for reasons of political pragmatism or otherwise, and which ones discarded or postponed.

Among these policies, the ones that have had the largest impact on financial markets have been the proposed tax cuts and infrastructure spending that aim to boost US growth through significant fiscal easing. Prima facie, the tax cuts and spending are large, but both analysts and the market have assumed that only part of the proposed policy changes will likely be adopted, at least this year, given that deficit hawks in Congress still command a blocking position. But even with only modest fiscal easing, long-term interest rates in the US have risen sharply and with that, the US dollar. This generalised tightening of global financial conditions has already resulted in substantial capital outflows from emerging market economies, including India, and depreciated currencies. More importantly, with the Federal Reserve now intimating a faster pace of normalisation of short-end rates, it is likely that the structure of US interest rates will rise further in 2017. Naturally, this does not bode well for capital inflows into EMs.

But wouldn’t the tide of higher US growth raise all boats? There are two sets of issues that complicate the answer. First, what impact might fiscal expansion have on the US economy? While it may not feel as such, the US economy has been expanding for the last 6-7 years and is now running close to full capacity. Indeed, most indicators suggest that the probability of recession in the US two years ahead has risen substantially over the last six months or so. In an economy with lots of excess capacity, fiscal expansion raises growth; the same policy in a maturing economy can end up raising inflation instead. If it is more of inflation, then both short and long-term interest rates could rise more aggressively.

Second, even if growth in the US were to rise in the near term, global trade dynamics have changed quite dramatically since 2012. In the decade before that, an increase in US growth by 1 percentage point typically raised EM growth by 1.2 percentage points. This was for two main reasons. The period coincided with rapid expansion of global supply chains such that higher US growth ended up increasing EM exports significantly. Domestically, EM corporates would take the rise in exports to be durable and respond by increasing investment. As a result, the impact of higher US growth on EMs would be amplified. However, with supply chains maturing since 2012, growth in global trade has languished. With export growth no longer a durable source of demand, corporate investment in EMs too has flatlined. Unsurprisingly, in this new normal, a one-percentage point increase in US growth has delivered only a 0.3-percentage point increase in EM growth. So, even if US growth does increase, the impact on EMs is likely to be small.

Thus, so far, EMs have had to endure all the negative impact for rising US interest rates and the dollar, awaiting an uncertain and small positive spillover in the future. On the external policy front, the collective concern in EMs is widespread. The threat to “renegotiate” NAFTA has already taken its toll on Mexico, while hopes of reviving the TPP without US participation haven’t fired anyone’s imagination yet in Asia. While fears of global trade wars appear overdone, labeling China a currency manipulator could be a very disruptive event in currency markets, especially in Asia. Ironically, it could also be counterproductive for the US. The allegation has been that China has purposely kept its currency undervalued to gain an unfair competitive edge. However, in the last two years, Chinese authorities have spent nearly $1 trillion to stop the currency from depreciating. If labelled a currency manipulator, markets are likely to depreciate the currency further rather than appreciate it!

Then there is House Speaker Paul Ryan’s corporate tax reform plan that could potentially have a much bigger impact on EMs than the changes to trade policies. The reform is ambitious in its scope and, if passed, could be the largest structural overhaul of US corporate taxes. But one critical element of the reform plan, blandly termed “border-adjusted tax”, could dramatically change global supply chains, trade and FDI flows. The US is one of the few countries that taxes corporates on the basis of global income — that is, it doesn’t matter where the firm sells its products, in the US or overseas. Almost all other major countries tax firms based on where the income is earned, typically within the country’s borders. The plan proposes to tax US firms based on the “destination” of its sales: Foreign sales (exports) would not be counted as revenue for tax purposes; foreign purchases (imports of goods and services) would not be deductible as expenses.

Without changing tariffs and avoiding a direct confrontation with the WTO, US imports would effectively be taxed at the corporate tax rate. Proponents of this change argue that this would reverse the offshoring trend among US corporates. Critics point out that this would affect only those companies who have offshored operations for a more favourable tax treatment and not for other cost factors. But even if only some of the offshoring is reversed, EM companies that are in the firing line (for instance, manufacturing in China and services in India) could be badly affected.

So we go into 2017 with uncertainty surrounding US economic policies with global repercussions. It could take the better part of the year before these are resolved. Hopefully, then, EMs will go back to repairing and recovering, as they were, before the US polls changed global financial conditions.

The writer is chief emerging market economist, J.P. Morgan. Views are personal.

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