Border adjustment, the Mexican peso, and Hoyt Bleakley

It now looks like the administration won’t (for now) be using its Economic Powers Act authority to impose a tariff on Mexican goods. Instead, he is going to ask Congress to create a border adjustment tax, which would stop American companies from deducting imports from their taxable income. At the same time, it would leave their exports untaxed. (Full explainer from Forbes, here.) 

So what would that do to the auto industry? Well, let us proceed in two stages.

1. What is the immediate impact on an American auto producer? Well, the border adjustment tax is less harmful than a tariff. The auto companies would not be able to deduct the cost of goods coming in from Mexican affiliates and suppliers, but they also would not be taxed on the cost of goods going out to Mexican affiliates and suppliers. But they would still have an incentive to source more inputs at home.
2. Except that the peso would fall (or the dollar would rise, same thing) in response to the tax. A 20% depreciation in the peso puts the auto company back where it started. 

But would Mexico allow the peso to fall that much? In the past, the Mexican central bank has acted terrified that depreciation would hammer Mexican corporations that had borrowed in dollars. That is a reasonable fear ... in theory.

In practice, it might not be. My friend and colleague, Hoyt Bleakley (with Kevin Cowan) looked at 450 non-financial firms in five Latin American countries. 

We consistently find that, contrary to the predicted sign of the net-worth effect, firms holding more dollar debt invest more than their counterparts in the aftermath of a depreciation. We show that this result is due to firms “matching” the currency denomination of their liabilities with the exchange rate sensitivity of their profits. Because of this matching, in equilibrium, the negative balance sheet effects of a depreciation on firms holding additional dollar debt were more than offset by the larger competitiveness gains of these firms.

In other words, depreciation might not be that harmful.

The other reason the central bank might not want to let the peso fall is fear of inflation. But that depends a lot on the reputation of the central bank and the structure of wage bargaining. Banxico is very credible and Mexico has weak unions, so while a fall in the peso will lead to a one-time increase in costs, it seems likely that Mexican workers would just have to suck up the fall in their living standards. It is hard to see how they could demand the kind of compensating wage increases that you would need to set off an inflationary spiral.

So yes, the peso could fall.

In short, the Trump tax would likely make Mexicans poorer with no compensating gains for American workers. But also no losses for fans of big American cars like the amazing Dodge Challenger, like my son. In other words, a gratuitous punch in the nose of those perfidious foreigners! And you can pretend that the tax flows are coming from those foreigners, when they are really coming from American consumers. 

Yeah, I can see why this might actually happen.