With Goldman's economic team having been subsumed by the Koolaid borg, lately we have been largely ignoring their once must read critical pieces, as the all out onslaught to prevent the ponzi collapse was started in November (we expect Hatzius to pull another 180 in April, just ahead of the May market crash which will lead right into QE 2+, but that is another story). This is a shame, because the team of Hatzius et al used to have insightful things to say. Alas, now all they do is cheerlead every single data point no matter how superficial or ugly the behind the headlines story is. Which is why we were pleasantly surprised to read the following research report by Goldman's Robin Brooks which discussed the consequence of the now seemingly inevitable tax holiday allowing multinationals to repatriate their cash without paying taxes. Following Obama's latest Wall Street corporatocratic hiring spree, we are now convinced that it is merely a matter of months if not weeks before this is announced. As such it will be a replay of the Homeland Investment Act of 2005. Oddly, this event has not be actively priced by the market. Goldman is correct that in all likelihood this will have a very dollar positive result, which likely explains precisely why the dollar has been allowed to drop so much against the euro, as the next leg will likely push the greenback well into the 1.20 range, if not lower. That this will happen just as the second round of European stress tests will only feed the flames of the EUR's collapse. The below piece examines Goldman's thinking of how this event will influence the EURUSD. Goldman, which is very client bullish on the EURUSD (and is therefore selling selling EURs in droves) states that it believes the likelihood of a HIA part 2 is very small, even as it frames the major strength the dollar would experience as a result. We agree with the latter and disagree with the former: one way or another, the Obama administration will need to get the $1+ trillion currently offshore. When that happens, watch as the EURUSD plunges to multi-year lows.
From Goldman's Robin Brooks and Alec Phillips
Another HIA as a possible catalyst for USD strength
A central part of our FX forecasts is that USD needs to fall on a broad trade-weighted basis, by between 4-5% by year-end. That said, we have been fielding a growing number of questions on whether there could be a new instalment of the 2005 Homeland Investment Act (HIA) and if this could be a catalyst for USD strength. Indeed, a number of US multinationals look to be pushing for another round of tax cuts for the repatriation of overseas profits. In today’s Daily, we discuss the potential for another HIA, or HIA2 as we call it here, as a source for USD strength.
We break the problem down into two three parts. First, we review the first HIA episode to see whether – empirically speaking – the 2005 HIA was a driver of USD strength. Once we control for interest rate differentials, which capture rising rate support for USD from a hiking Fed, HIA-related flows are not associated significantly with USD moves into end-2005. That said, we at the time observed sizeable FX flows on the back of HIA. These flows were quite concentrated and may indeed have moved USD in ways our empirics may not capture. We therefore do not dismiss HIA flows as a potential USD driver, and point here only to another possible driver for USD strength back then (a tightening Fed). Second, given this empirical evidence, we assess the potential for HIA2 to start another round of repatriation flows by US multinationals. Even allowing for the possibility that some (perhaps even a majority) of earnings retained overseas may be held in USD, the scale of US multinationals’ retained earnings abroad is such that HIA2 could result in potentially large repatriation flows. Third, and finally, against this backdrop the question becomes whether HIA2 is at all politically likely at this point – and here our reading is that it is not. Indeed, those members of Congress that made a push for the HIA in 2005 are in our understanding focused elsewhere, and – a December visit by US CEO’s with the President aside – there appears to be little political momentum in this direction.
3. A quick refresher on the 2005 HIA
We can proxy for repatriation flows by US multinationals due to the 2005 HIA by looking at repatriation flows in the US balance of payments. There is an element of judgement here, since it is unclear how much US multinationals would have repatriated in the absence of the HIA. However, if one allows for the fact that US multinationals’ distributed earnings flows averaged around $20 bn per quarter prior to the HIA, distributed earnings flows in Q1 2005 exceeded this amount by $13 bn, in Q2 by $23 bn, in Q3 by $77 bn, and in Q4 by 106 bn, for a total of estimated repatriation flows from the HIA of around $220 bn (Fig 1).
On the face of things, the associated spike in distributed earnings is indeed associated with a drop in EUR/$ (Fig 2), though this FX move could also be – empirically speaking – due to the rate differential between the US and the Euro zone moving in favour of USD, a reflection of a Fed embarked on a hiking cycle while the ECB only began hiking end-2005 (Fig 3).
Which of these two drivers matters more in explaining the USD rise into end-2005 is an empirical question, which we address here using simple regressions. We regress quarterly percent changes in EUR/$ on changes in the two-year swap rate differential and changes in the profit repatriation flow. This regression reveals the expected sign on both coefficients – stronger repatriation and higher US interest rates boost USD – but only the interest differential is significant. This result holds true whether we allow for lags in the link from FX to repatriation flows, or whether we run the regression in levels (where the sign on repatriation flows is wrong). That said, the explanatory power of all these regressions is low, and thus we put little weight on them. Indeed, back in 2005 we observed sizeable FX flows on the back of HIA. These flows were quite concentrated and may indeed have moved USD in ways our empirics may not capture. We therefore do not dismiss HIA flows as a potential USD driver, and point here only to another possible driver for USD strength back then, in the form of a tightening Fed, not to mention of course also the rejection of EU referenda in France and the Netherlands, and positioning, which may also have worked against EUR.
4. Large potential for another round of repatriation flows
US companies have accumulated substantial retained earnings abroad since the last round of repatriation in 2005. Estimating the stock of retained earnings that (a) could be repatriated in the event of HIA2 and (b) would be FX relevant is a heroic exercise at best. That said, cumulative retained earnings of US multinationals since end-2005 are around $1.2 tn. The previous HIA legislation limited repatriation to earnings reinvested abroad listed on corporate balance sheets as of roughly 1.5 years prior to enactment, in order to avoid corporate gaming of the incentive. If such a restriction applied again, for instance limiting eligible profits to those on record at the end of 2009, this would reduce the potential amount to $925 bn.
However, most firms that might repatriate funds under HIA2 are Dollar functional and tend to keep the vast majority of cash assets in USD, regardless of the tax jurisdiction. Thus the actual FX transactions resulting from repatriation would only be a fraction of total repatriation flows, and we think 10% could be a reasonable assumption based on past HIA flows. Moreover, US firms would likely not repatriate all their retained earnings overseas, even in the event of HIA2. One limiting factor that could come into play in any future repatriation regime is a stricter limitation on eligible uses of funds. In the 2004 episode, firms were required to demonstrate that eligible payments to US parent companies were used to invest in plant, equipment, research, hiring or training. However, there was no requirement that this requirement be incremental to normal investment patterns, and in most cases the requirement was not a binding restraint. If Congress were to consider another round of repatriation incentives, it seems likely that some type of incremental investment requirement would be required. This could significantly dampen appetite for profit repatriation, given that the same large US corporations that have earnings stranded overseas face minimal financing restraints domestically and thus are unlikely to want to increase investment based on the availability of funds.
But even allowing for these various things, at least conceptually the potential for sizeable repatriation flows is clearly there.
5. HIA2 is not on the political front burner
Against this backdrop the question becomes whether HIA2 is at all politically likely at this point – and here our reading is that it is not, for three reasons. First, most of the members of Congress that made a push for the HIA in 2005 do not appear to be particularly focused on it this time around. Instead, most of the recent discussion of a repatriation tax holiday appears to be generated by companies seeking another round of relief—including CEOs meeting with the president late last year—rather than by interest on Capitol Hill.
Second, although the fiscal effects of allowing a repatriation holiday are certainly debatable, the official estimate is likely to imply a significant cost to such a proposal. For instance, the original HIA was estimated to reduce corporate tax receipts by $3.2 bn over ten years, which was comprised of a revenue increase of $2.8 bn in the first year, followed by $6 bn in reduced tax receipts in the following years. This implied flows of at least $50bn ($2.8bn/5.25% tax rate). Even if the revenue loss is offset by other factors (for instance, use of foreign tax credits would be limited if a repatriation holiday were granted), this still implies a revenue effect in the tens of billions. This could create difficulty in the current fiscal climate.
A third and somewhat related factor is the growing interest in corporate tax reform taking hold in Washington. President Obama appears likely to identify tax reform—and particularly corporate reform—as a priority in his State of the Union address on January 25 and in his budget that will follow mid-February. Likewise, congressional Republicans have also highlighted tax reform as an important issue. While corporate tax reform could create an opportunity for greater repatriation of profits on an ongoing basis, with tax reform on the horizon legislators appear less interested in near term tax changes. Indeed, in testimony in the US House this week on the subject a representative of the Business Roundtable (an umbrella group representing corporate CEOs) indicated that the group prefers to focus on a permanent reduction in the statutory corporate tax rate and reform in the treatment of overseas profits rather than another temporary repatriation tax holiday. While some individual companies hold a different view, our sense is that the appetite for one-off changes will diminish further as the debate over wholesale reform picks up.