HIA - Research

Market Musings Global Strategy 16 December 2016 | TD Securities | Toronto

Breaking Down the Impact of HIA 2.0 on FX 

The Republication sweep has brought fiscal policy back on the table with corporate tax reform high on the to-do list, rekindling thoughts of the HIA in 2004.

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We estimate a stock of nearly $2,000bln in foreign earnings but think this number significantly overstates the expected FX flow on corporate reform.

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For the USD, an implication of our analysis is that tax reform could amplify the cyclical tailwind into 2017, boosting gains against EUR, GBP, JPY, and CAD. But a push towards HIA 2.0 is not a gamer-changer for FX.

A revamp of the tax code could see this issue brought back to light. Recall that the corporate tax rate is 35% and corporate tax reform is one area where the House Republications and the Trump administration can easily strike a deal. Policymakers have argued for years that the US corporate tax rate is too high and puts US corporates at a disadvantage against foreign competitors. The policy argument is that low corporate tax rates would improve competitiveness and thus improve growth and employment prospects. Some observers point out that the US corporate rate of 35% is higher than the OECD average, though reports have shown the US’s effective corporate tax rate is much more competitive than the headline.

The Republican sweep of the election has brought fiscal policy and tax reform back on the table. For many market participants, the potential repatriation of corporate cash locked overseas has shifted on the radar screen. This reflects the large stock of overseas earnings and the possible impact these flows could have on USD-denominated assets. Indeed while policy uncertainty remains high, many observers see tax reform as low hanging fruit for the Republican majority. We think this increases the scope of corporate tax reform in 2017. For investors, this topic kindles thoughts of the Homeland Investment Act (HIA), which got approved in 2004. The goal of the original HIA was to incentive firms to repatriate overseas cash to boost local demand and generate job growth. Estimates suggest that firms brought home roughly $350bln, creating a total deduction of $265bln. For the economy, the net impact of the 2004 HIA was probably a disappointment since most of the cash was paid out of as dividends or reinvested in local equities rather than put to work in the economy. Private investment barely budged yet the S&P climbed roughly 12% in 2004 and 2005 while the DXY posted a 13% rally in 2005.

Regardless of the policy debate, the market impact will depend mostly on the amount of outstanding cash and, more importantly for the FX market, the amount denominated in foreign currency. We estimate that US corporates have accumulated around $1,965bln in foreign earnings since the completion of the first HIA. Currently, this number represents the full stock of capital outstanding, making it a starting point of possible flows. However, it is important to keep in mind that only a portion of this capital is likely to get repatriated. For the most part, a large chunk of the overseas capital is necessary for business operations (investment and expenditures) outside the US—not tucked away to avoid taxes. Still, research suggests that the HIA saw around 17% of foreign earnings return home. Using that figure as reasonable benchmark, we assume that an HIA 2.0 could see about $334bln returned to the US, which is around 2% of GDP. This number closely resembles the total amount seen in 2005 but is probably smaller than some of the news headlines suggest. Corporate filings show that the bulk of the earnings are concentrated in a few sectors, namely tech and health care. The findings from the IRS study show that only about 10% of corporations took advantage of the deduction linked to the HIA. Keep in mind, though, that the first HIA law was voluntary so a mandatory repatriation could result in larger flows.

Market Musings 16 December 2016 | TD Securities | Toronto

Still, we see scope for these flows to amplify daily moves and could add further tailwinds to the USD. According to the BIS data, EUR and JPY account for 41% of daily spot flow while GBP, AUD, and CAD account for a tad under 20%. For HIA 2.0, we believe these estimates are a good proxy for the amount of flows that might get pushed through the market. We also note that these currencies also saw the biggest impact during HIA. All told, this leaves the EUR, JPY, GBP, and CAD the most exposed to any one-off changes in the result of the passage of a new HIA 2.0. But, as they say, the devil is in the details and other factors will also drive the FX impact.

These numbers suggest that the outstanding stock and possible inflows could be quite large. We caution, however, that the impact on the FX market would likely be much smaller. For one thing, the impact on the currency market will hinge on the amount of money held in non-USD. There is no hard data that shows this figure so, again, we have to make some assumptions. Anecdotes from corporate filings suggest that most of these firm’s holdings are currently in USD or are hedged. The main reason for this is the incentive to avoid currency volatility. Suffice that to say, a reasonable working assumption is around 25% of these flows are in non-USD FX. At the same time, our estimates imply that a HIA 2.0 could generate a possible $100bln in FX flows. Our estimates are probably a bit on the conservative side, so we think the potential flows is probably biased to the upside. The Congressional Research Service, for instance, produced a paper in 2011 that showed holdings of foreign currency were 54%. This level of foreign currency denominated earnings could see the potential FX flow nearly double our estimates, likely generating bigger moves in the FX market. We caution, however, that over the past few years tax reforms (similar to HIA) have crept up in public discussion, so it is possible firms have dialled back exposure to foreign currencies as a result. For the currency response, the potential for a sizeable one-off flow need to be taken in context with the overall size of the FX market. We suspect that the bulk of these profits are held in DM rather EM countries. Indeed, the country–level breakdown of the foreign profits held abroad suggest most of the flows are held in the Eurozone, UK, Japan, and Canada. Moreover, the BIS estimates show that the top five most traded currencies have a daily net turnover around $3,000bln. Compared to 2004, volumes are now over the twice the size of the level seen in 2004. This could potentially blunt the impact of a new HIA 2.0 on the USD—at least when compared to HIA. These numbers demonstrate that the flow impact of corporate tax reform is unlikely to sway major trends in the FX market.

For the US, corporate tax reform could have a notable impact on the balance of payments. The chart above shows the impact of HIA on the broad balance of payments (BBoP). It shows the pickup in flows (linked to the reform) saw the BBoP (% of GDP) rise to zero in 2006 from a 2% deficit in 2004. The effect was most pronounced in foreign direct investment (FDI) since accounting principles showed a surge in foreign inflows come back to the US. This helped to offset the current account deficit, generating support for USD-denominated assets. Portfolio flows also saw a notable boost, which lifted equities. This time around, a sizeable pickup in flows could reaffirm the stronger tone in the greenback. Indeed, compared to the mix in 2004, the current composition of the US balance of payments shows a smaller current account deficit and a stronger uptake in portfolio flows —both good for the USD. Finally, it is important to keep in mind that other cyclical drivers matter, arguably more. For one thing, the passage of HIA predated the start of a Fed tightening cycle in 2005. This cycle saw the Fed tighten the policy rate by 425bp, which probably played a larger role in the greenback rally when compared to the passage of tax reform. At the very least, we suspect the impact of the HIA reform was to amplify the rally in the greenback, prompted by the Fed hikes. We see a similar dynamic at play next year if policy makers strike a deal on tax reform given our expectations of further Fed hikes. 2


Arguably, corporate tax reform in the mid-2000s probably benefited equities the most since a bulk of the flows found their way back into the stock market, through dividends, share buybacks or M&A deals. We think the equity market link is an essential way to think about corporate tax reform now given this dovetails nicely with the current backdrop. Namely, HIA 2.0 would probably boost stocks, helping to support financial conditions. Stronger financial conditions and stronger growth aim to keep the Fed normalization on track. This feeds back in USD strength until the current account deficit expands or currency strength becomes self defeating, sending this feedback loop into reverse, this is a longer-term implication. The last lesson is that most of the foreign exchange market impact will likely get frontloaded on the announcement, highlighting the “buy the rumor, sell the fact” nature of market participants. We believe this adds a tailwind to our upbeat USD view at the start of the year and prefer to hold shorts in CAD, EUR, and JPY through at least the first half of next year.

Mark McCormick +1 416 982 7784

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