Donald Trump looks poised to deliver a seismic shift to the ground on which the U.S. dollar, and by extension the entire global currency market, is built. But if you thought it was already unclear what that shift would look like, this week's contradictory signals took the view to a whole new level of murky.
About the only thing that's becoming clear is that what was already shaping up to be a year of change for currency markets is getting more uncertain and volatile – and that could complicate the struggling global economy in any number of ways.
Consider the depth of uncertainty that the new U.S. President has in short order heaped on the U.S. dollar, the world's dominant currency. Mr. Trump continues to push a protectionist trade agenda, threatening steep border taxes on any company setting up plants outside the United States to make goods for the U.S. market. In Washington, Republican lawmakers are pursuing an overhaul of the corporate tax system that would effectively tax U.S. companies for goods and inputs that they import, at a proposed corporate tax rate of 20 per cent, while exempting income they earn from exports. The changes, economists generally agree, would trigger a substantial gain in the U.S. dollar.
But Mr. Trump said in an interview with the Wall Street Journal this week that the already strong U.S. currency, which has been trading at 14-year highs against a basket of major foreign currencies, "is killing us," making it impossible for U.S. companies to compete with Chinese manufacturers. He suggested the United States might have to act to "get the dollar down" if his trade policies put upward pressure on the currency. His comments triggered a quick sell-off of the dollar.
Then Mr. Trump's nominee for treasury secretary, Steve Mnuchin, reversed the message again. "The long-term strength of the dollar, over long periods of time, is important," he told a Senate confirmation hearing Thursday. By Friday's presidential inauguration, the new Republican presidential administration was distancing itself from the Republican Congress's corporate tax plan – possibly setting the stage for a showdown with its own party.
Through all those mood swings, the U.S. dollar escaped the confusing week down slightly from where it began. Yet the market's best guess remains that a Trump presidency, arriving with arguably the most openly protectionist trade platform since Herbert Hoover, probably means that an already rising U.S. dollar will face considerably more upward pressure.
Even without Mr. Trump's desire to rewrite trade rules in favour of U.S. producers and to punish the country's perceived trade foes, there were compelling forces propelling the currency, which has gained nearly 10 per cent in global markets in the past eight months. The U.S. economic recovery is far ahead of those of other advanced economies, and its labour market is approaching full employment. Its central bank, the Federal Reserve, raised its key interest rate in December and looks on track to raise it several more times over the next year, to tap the brakes on an economy approaching full capacity – at a time when most other central banks, including Canada's, are a long way from rate hikes.
The relatively strong growth and rising interest rates are already more than enough to draw buyers to U.S. dollars; Mr. Trump's proposals to cut taxes and boost infrastructure spending have served to further raise rate and growth expectations. But since Mr. Trump stepped up his trade rhetoric to start the New Year, the market's focus has been on the potential for dramatic changes in trade policy to launch the greenback into a new stratosphere.
"It's very general right now, but [Mr. Trump's] priority is 'America first,'" said David Doyle, North American economist and Canadian strategist at Macquarie Group, echoing a phrase Mr. Trump emphasized in his inauguration speech. "Directionally, it's all toward a stronger U.S. dollar."
For Canada, which depends on the U.S. market for roughly three-quarters of its exports, that implies that it can expect its currency to weaken against that of its biggest trading partner. But how much weaker is, at this stage, anyone's guess.
Economists say that at least theoretically, in a market of free-floating currencies, a 20-per-cent border-adjustment tax imposed by the United States on its importers should result in a 20-per-cent rise in the U.S. dollar – the currency valuations would adjust over time to reflect the full size of the change in the terms of trade. That implies that the Canadian dollar could be destined for a corresponding 20-per-cent fall against the greenback. That would be on top of the modest declines that most currency strategists already anticipate for the loonie this year, as the gap between Canadian and U.S. central-bank interest rates widens. In this scenario, the Canadian dollar could sink to record lows, below 60 cents (U.S.).
But that looks like the extreme case, said Mark Chandler, head of fixed-income and currency strategy at Royal Bank of Canada, who believes that any border tax wouldn't cover the full range of imports. To get a more plausible sense of the hit the proposed border adjustment might deliver, Mr. Chandler has focused on the $120-billion a year in tax revenues that the Republican lawmakers have estimated the proposed tax will generate. Based on Canada's share of U.S. imports, he said, that would imply about a $15-billion take from Canada.
That amount, he said, would represent about a 4-per-cent to 5-per-cent "terms-of-trade shock" for Canada's exports – implying a currency correction of about that amount. To put that in perspective, that's about half the terms-of-trade hit that Canada suffered from the recent oil shock. The Canadian currency shed about 14 per cent between the end of 2014 and the end of 2016, constituting the meat of the oil shock's effects.
Arguably, any protectionist moves by the Trump administration would be an even bigger deal to Mexico, which relies on the United States for 80 per cent of its exports, and China, which has surpassed Canada to become the U.S.'s biggest trading partner in recent years. Indeed, Mr. Trump specifically cited both countries during the election campaign as the targets for his trading ire, even raising the possibility of 35-per-cent tariffs on their imports. If that happened, those currencies would face even more downward pressure than Canada's, although there is a growing sense that those threats are largely a hardline negotiating ploy on Mr. Trump's part.
In Mexico, where exports account for 35 per cent of gross domestic product (more than Canada's 31 per cent), the peso has already shed more than 15 per cent since the November election, amid fears that Mr. Trump has painted a target squarely on the country's back. J.P. Morgan Securities' currency strategists believe the peso could still fall another 15 per cent if the Trump administration succeeds in pushing through a hard line on Mexican trade and renegotiation of the North American free-trade agreement.
Whatever the currency adjustment, economists point out that it's not necessarily a bad thing; in fact, that's how a flexible exchange rate is supposed to work. The Bank of Canada often talks about the importance of having a flexible currency, especially for an export-intensive economy such as Canada's, to help the economy weather external shocks – like, say, a sudden and dramatic shift in the terms of conducting trade with the United States.
Indeed, many economists believe that if the Trump administration were to impose new border levies of any kind on imports, the resulting currency adjustments could largely make the impact a wash. The lower currency values for trading partners would improve the value of their U.S. sales in terms of their domestic currencies, cancelling out the higher costs imposed by the tax. And the higher U.S. dollar would make U.S. exports more expensive for foreign buyers, thus mitigating the competitive advantage the tax was supposed to give them.
One area of potentially bigger concern, though, is the impact a further significant increase in the U.S. dollar might have on developing countries, many of which are carrying substantial debt that is denominated in U.S. currency – debt that becomes more expensive whenever their local currencies lose ground to the U.S. dollar.
According to World Bank statistics, nearly three-quarters of developing countries' external government debt, or nearly $5-trillion, was denominated in U.S. dollars as of the end of 2015. These U.S.-dollar debts have more than doubled since the 2008-2009 financial crisis. And it's not just governments that have loaded up: A recent report from the Bank of International Settlements pegged U.S.-dollar corporate debt in emerging economies at more than $3-trillion – roughly $340-billion of which is due for repayment by the end of 2018.
"The high indebtedness of [emerging market economies'] corporate sector rings alarm bells," the BIS report said. "Some of their non-financial companies have borrowed heavily, with much debt denominated in U.S. dollars."
For that reason, some prominent economists are warning that a set of trade policies that trigger a surge in the U.S. dollar could do more than disrupt trade – it could put the global financial system at risk.
Harvard University economist Lawrence Summers, U.S. treasury secretary under Bill Clinton, cautions in an op-ed in the Washington Post earlier this month: "This would do huge damage to dollar debtors all over the world, and provoke financial crises in some emerging markets."