How border adjustment could trigger a series of emerging market crises

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A central feature of House Republicans’ reform plan is the introduction of a border adjustment – a combination of a tax on imports and a subsidy for exports. As I have discussed before, most economists assume that nominal exchange rates will adjust to undo the terms-of-trade effects of this policy change.

If that happens instantly and no one anticipated it, trade will not be affected. But there will be drastic shifts in the foreign-currency value of assets and liabilities denominated in dollars, and this would have dire consequences for emerging-market firms and sovereigns. The logic here is straightforward: if you borrow in dollars, and the value of the dollar rises, your liabilities become greater. And if your income is not in dollars, it becomes harder to service your debt.

A man observes a board showing the Brazilian Real-U.S. dollar and several other foreign currencies exchange rates in Rio de Janeiro, Brazil November 9, 2016. REUTERS/Sergio Moraes.

As my colleague Desmond Lachman has emphasized, this comes at a time when emerging economies have been taking on large amounts of debt. This would be a concern even without the exchange rate adjustment induced by border adjustment, as inflation has been creeping up in the US and full employment is in sight. The Federal Reserve has, in response, started tightening and is expected to continue doing so. This has led to a dollar appreciation, and further rate hikes will presumably continue to do so, drawing capital away from emerging markets and placing upward pressure on the interest rates faced by by both governments and corporations in emerging economies.

A sudden 25% appreciation of the dollar would add significantly to this concern. According to the Bank for International Settlements, about a third of all dollar-denominated debt outside the US originated in emerging markets, or over $3 trillion. 25% of that is over $750 billion, and that is how much more these borrowers would now owe in terms of their local currency.

For example, according to the Central Bank of Turkey, domestic corporations have borrowed about 50% of GDP in dollars. More than half of that is in dollars, and border adjustment would therefore deliver a potential $60 billion blow to Turkish firms. That would be, to put it mildly, unhelpful right when Turkey is dealing with massive refugees inflows, severe domestic political instability, and all-out war between ISIS, Assad, Russia, and a number of other parties just across its borders.

The risks posed by this potential implication of corporate tax reform should be of concern to investors and policymakers in the US as well. Not only are some of the dollar-denominated loans issued in emerging markets held by American citizens, firms, and pension funds, spillover effects from abroad could harm the broader US economy as well.