Trump, taxes and trade: why emerging markets must prepare now for the US shock waves
Shang-Jin Wei says higher levels of FDI and greater exchange-rate flexibility could be safeguards for China and other developing economies set to experience volatility as President Donald Trump puts America first
With a series of tax and trade moves being considered in the United States this year, emerging-market economies are likely to face devaluation pressure and volatility. Three sources of US-fuelled economic uncertainty, in particular, will rattle emerging markets in 2017.
The first is a border adjustment tax that would give tax breaks to US exporters, but impose a levy – or, equivalently, disallow deductions – on imports to the US. Both President Donald Trump and the Republican-controlled Congress have said they favour the scheme, which has a fair chance of being enacted. Such a tax, or even its anticipation, could drive up the US dollar’s exchange rate (which, ironically, would offset, at least partly, the improvement in the US trade imbalance for which the Trump administration may be hoping).
The second source of uncertainty is the possibility of more aggressive action on Chinese exports to the US. The Trump administration has said many times that it will confront China over what it considers unfair trade practices.
US restriction on imports from China would translate into reduced exports of value-added items by other Asian countries
But such a move would serve to weaken many other currencies as well. Our research reveals that about half of Chinese exports to the US are value-added products manufactured with components from South Korea, Japan, Taiwan, Singapore and other countries. Because products from China are often part of integrated global or regional value chains, a US restriction on imports from China would indirectly, but very quickly, translate into reduced exports of value-added items by other Asian countries. This would likely offset any direct increase in their exports to the US, at least in the short and medium term, because re-organising production chains is not a trivial matter.
A third US move that could unsettle emerging markets is faster-than-expected monetary tightening by the Federal Reserve. A large interest rate hike would translate into US dollar appreciation, and depreciation of developing economy currencies.
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One exception may be the currencies of commodity exporters. Higher commodity prices, triggered in part by anticipation of increased demand amid a boost in US infrastructure spending, could cause their currencies to strengthen. But some commodity exporters – such as Brazil and Russia – may not see much improvement in exchange rates, given the drag of other forces on their weak economies.
The challenges that US policy changes pose for emerging-market currencies include not only downward pressure, but also greater volatility. What, then, should emerging-market countries do to enhance their resilience in anticipation of the shock waves?
If developing countries fail to prepare, they will have to prepare to fail
One option is to optimise the structure of capital inflows. A second is to boost the flexibility of exchange rates.
On the former, countries that rely heavily on borrowing from foreign banks or international capital markets are more vulnerable to capital flight than those that depend mainly on foreign direct investment. Therefore, emerging markets should work to improve their business environments to attract FDI, which would reduce their reliance on short-term infusions of “hot money” – and thus lower their vulnerability to abrupt capital-flow reversals.
As for the second option, allowing nominal exchange-rate flexibility would enable currency values to align with underlying economic fundamentals more quickly. Such an adjustment is especially important for countries with rigid labour markets. One danger of fixed exchange rates is the risk of an overvalued or undervalued currency, neither of which is good for economic stability. The chance of either scenario is elevated when the forces influencing the equilibrium exchange rate become more volatile.
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While the shape and timing of future US policies are uncertain, it seems clear that capital-flow management and nominal exchange-rate flexibility amount to good preparation. To paraphrase Benjamin Franklin, if developing countries fail to prepare, they will have to prepare to fail.
Shang-Jin Wei, a former chief economist of the Asian Development Bank, is professor of finance and economics at Columbia University. Copyright: Project Syndicate
