Let me provide the link to U.S. Treasuries as reserve holdings: take an emerging market corporate issuer raising money in U.S. dollars because of what used to be a funding advantage: upon issuing debt (raising cash), they might sell dollars to buy the emerging market currency to fund their operations. In the meantime, their government buys U.S. dollars and subsequently U.S. Treasuries to sterilize the corporate issuer’s sale of the dollar. Due to regulatory changes in U.S. money market, it may now be no longer advantageous to issue debt in U.S. dollars, eliminating the downstream effects, including the holding of Treasuries as a reserve asset.
- A second change is under consideration: the House GOP tax proposal would eliminate the deductibility of net interest expense. If passed, it could have profound implications on how issuers around the globe get their funding, as we shall explain below.
If corporate America can no longer deduct net interest expense, we believe it will make the use of debt less attractive. It would discourage the use of leverage. Banks use a lot of leverage. And, as we are pointing out, one can look at the U.S. as a whole as if it were a bank. A system with less leverage may well be more stable; however, a system that uses less leverage may also have less growth.
From the point of view of America’s exorbitant privilege, the key question in our view is how the world reacts. A plausible scenario to us is that American CFOs will move leverage to overseas entities where interest continues to be deductible. Similarly, to the extent that foreign issuers in the U.S. used U.S. legal entities to raise money, they would likely raise funds through foreign entities where interest expense would still be deductible. The question then becomes whether the money raised from these (newly minted) foreign entities would be in U.S. dollar or in foreign currency. If they raise money in foreign currency, the U.S. dollar would be cut out as the “middleman,” jeopardizing American exorbitant privilege.
If you take a U.S. firm, if they decide to use foreign subsidiaries to issue debt, they might want to also report more revenue overseas to make it worthwhile to deduct more. CFOs are highly paid, in part we believe, because of their ability to engineer where to recognize revenue and expenses. We would expect CFOs to rationally optimize shareholder value in the context of the regulatory and tax framework they are presented with. Once you take the step of recognizing more revenue abroad, it would only be prudent to match the liability, i.e. the interest expense, in the same currency.
But won’t the U.S. be a more attractive place to invest if the entire GOP tax plan gets passed? What about if the U.S. changes to a territorial tax system? What about the border adjustment tax (or a variant thereof)?
- If the U.S. were to move to a territorial tax system, i.e. no longer tax corporations on their global income, it may provide a further disincentive to issue U.S. debt. In the current tax system, corporations issue U.S. debt to fund domestic operations while avoiding the repatriation of foreign earnings.
- The concept of a border adjustment tax still needs to take shape before we can have a more definitive opinion about it. From what we see, it appears to foremost provide a one time shock to the system (possibly causing a one time inflationary impact as the cost of higher imports gets passed on to consumers); that said, corporate America might come up with a variety of tricks to mitigate the impact of such a tax (e.g. exporting fuel to their plant in Mexico, thus being able to deduct the cost of energy from imported goods).
- Not much discussed, but a potential U.S. dollar positive would be if indeed investments could be fully expensed the first years rather than a requirement to amortize expenses over many years, as in the current tax code. That is, if the U.S. incentivized investments over spending. We’ll discuss this in more detail once we have more clarity on the actual tax reform.
There’s still one more component: a U.S. government that needs to issue a lot of debt to fund its budget deficits. To the extent that foreign governments have less of a need to hold U.S. dollar reserves, funding costs for the U.S. government might rise. While some may believe higher borrowing costs might be a positive for the dollar, the opposite may be true if the Federal Reserve has to keep rates artificially low to prop up an economy that would otherwise deflate; or because government deficits would otherwise be unsustainable. The point being here that the U.S. dollar might become more vulnerable should fiscal and monetary policy not be sound...