Resurgent dollar threatens to 'cripple' Chinese growth
Previous dollar spikes have proved profoundly destabilising for the world economy. This one may be no different, with China the most likely casualty
6:48PM GMT 04 Nov 2014
It doesn’t pay to bet against the dollar - at least, that’s the latest mantra in notoriously fickle foreign exchange markets. All of a sudden, everyone seems to be taking the view that currencies are on the verge of one of their periodic, once-in-a-decade seminal shifts, with the dollar likely to strengthen significantly over the next several years. Some big bets have been placed on it.
In one extreme case back in the 1980s, one such surge added more than 90pc to the dollar’s trade-weighted value. With the global financial system still chained to the mast of dollar hegemony, these periods of dollar strength have tended to presage – some might say even cause - outbreaks of extreme financial and economic instability. Unless it acts quickly to decouple, the main “victim” of a resurgent dollar this time around will likely be China, which is effectively pegged to the greenback and whose exports are highly dependent on a relatively weak currency. But if it wanted to float so as to free itself of this disadvantage, could it afford to?
Everywhere you look, financial analysts have turned bullish on the dollar. The only real surprise is that there’s not been more strength already, for although it's at a four-year high, the dollar is still weak by historic standards.
Intuitively, this weakness has felt wrong for some time now. For starters, the US recovery is stronger and longer than almost anywhere else among the advanced economies; what’s more, after years of quantitative easing, Federal Reserve asset purchases have finally been brought to a close. Relative to where we have been, the end of QE counts as monetary tightening. Relative to others, it even counts as something akin to monetary discipline. As America weans itself off the monetary steroids, Japan is going full tilt in the other direction.
With Europe now perilously close to outright price deflation, it can surely only be a matter of time before Japan is belatedly joined in its monetary expansionism by the European Central Bank. Korea is already chasing hard in this latest outbreak of beggar thy neighbour currency wars. Thus does each region hope to offload its deflationary pressures onto others.
As things stand, there is no reason to believe the US will attempt to fight dollar strength, even though it puts further downward pressure on an inflation rate that is already perilously close to 1pc. Republican dominance of Congress afterthis week’s mid-terms will not affect this mindset. Republicans are not natural protectionists, and won’t be clamouring for corrective action. Nor do they need to. The US economy is driven overwhelmingly by internal, domestic demand. Exports are not so important to its fortunes.
And in any case, the pressures work both ways. Weakening demand elsewhere in the world, particularly in emerging markets, is depressing commodity and energy prices. This is unhelpful to further development of US shale, but it makes American consumers better off. The greenback will need to go a lot higher before US policymakers hit the panic button.
For others, however, the panic may be more immediate. At Fathom Consulting, Danny Gabay reckons that Chinese growth may already have dipped to less than 5pc on an annualised basis. It’s a view shared by Diana Choyleva, of Lombard Street Research.
And it’s hard to argue with their prognosis. Even the Chinese premier, Li Keqiang, has said he finds the official Chinese GDP figures unreliable. Using his preferred measures of electricity consumption, rail freight volumes and credit growth, you get a much lower number than the officially targeted 7.5pc rate.
If these more pessimistic estimates for the Chinese economy are even halfway true, then any significant strengthening in the US dollar would virtually guarantee a hard landing. Chinese policy makers don’t like to do anything in a hurry, but a strengthening dollar is a major headache for an economy already at risk from a deflating credit bubble, and could therefore significantly speed up the process of capital liberalisation.
Whether China is quite ready for such a revolution is an interesting question. Quite apart from any other considerations, the Chinese corporate and financial sectors have some big dollar debts. These are made bigger still by dollar appreciation, threatening multiple bankruptcies.
Even so, the Chinese authorities have already quietly ceased attempting to support the renminbi/dollar peg with asset purchases. Just a few years back, Chinese reserve accumulation used to be characterised as barely legal currency manipulation. There was outrage on Capitol Hill, and repeated calls for tariffs on Chinese goods. Back then, the Chinese policy goal was to stop the renminbi appreciating against the dollar, so that Chinese exports could remain competitive.
The irony is that if the peg was abandoned today, it wouldn’t be renminbi strength the Chinese would have to worry about, but the reverse – rapid depreciation. Decoupling would be a huge step for a country that has built its economic success in lockstep with the dollar. However, in a world where demand is increasingly hard to find, it may yet come to that.
There’s a long way to go yet but in the past, when the dollar gets so high that the pips start to squeak, the US eventually does act. One such episode was in the mid-1980s, when the dollar reached virtual parity against the pound. As an alternative to the bogey of protectionism, the world’s five major economies – the US, Japan, Germany, Britain and France - reached an agreement to sell the dollar until a more normalised exchange rate returned - the so-called Plaza Accord. It worked so well that, two years later, they had to put it all into reverse with the so-called Louvre Accord to support a dollar which was by then in freefall.
But the damage had already been done. The recessionary effects of the strengthened yen on Japan’s export-led economy created the incentives for expansionary monetary policy, which in turn helped inflate Japan’s asset bubble. When this burst, it resulted in two lost decades of growth.
Such are the dangers of manipulating the dollar. Something similar may have happened when the dollar last spiked in the late Nineties to early Noughties. This was the heyday of Chinese currency manipulation. China saved while America spent, creating vast and unsustainable trade and capital imbalances. The financial crisis followed as surely as night follows day.
Both these spikes also caused crises on the way up – the Latin American crisis in the Eighties, and the Asian crisis in the late Nineties. Today, there is not so much public borrowing in US dollars outside America itself, but private sector dollar debt is off the scale by past standards.
Mighty changes are again afoot in global currency markets. The effects are as yet unpredictable, but they are most unlikely to be benign.
