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A Strong Dollar Hurts China More Than the U.S.

The biggest loser from a stronger dollar may be China, not the U.S. And that’s why some economists predict the Asian nation will loosen its currency’s link to the greenback and allow the yuan to depreciate.

The People’s Bank of China took what may be a small step in that direction on Wednesday when it cut the currency’s reference rate to 6.4140 per dollar, its weakest level since 2011. The Asian nation has tethered the yuan, for the most part, to the dollar in order to enhance financial stability. That means as the dollar advances against most currencies across the world on expectations of rising U.S. interest rates, the yuan does, too. China suffers more, though, because its slowing economy is almost twice as dependent on trade.

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“It’s a problem,” said Yukon Huang, a senior associate at the Carnegie Endowment for International Peace in Washington and a former World Bank country director for China. “Excessive appreciation at a time when the economy is sinking is a bad thing.” He and other economists, including former U.S. Treasury Secretary Lawrence Summers, expect China will try to avoid that by allowing the yuan to fall against the dollar. Such a move, though, risks triggering political criticism in the U.S. with a presidential election less than a year away.

Under Attack

“They’re stuck,” Huang said. “If they depreciate the currency, they’ll come under attack.” Yet “they need to do so.” Republican presidential front-runner Donald Trump has called China the “No. 1 abuser" of the U.S. and has accused it of “wanton manipulation" of its currency.

The U.S. economy certainly has been hurt by the dollar’s advance since mid-2014. (It is up more than 20 percent against a basket of currencies during that time, though only about 3 percent against the yuan.) The stronger greenback has made American companies less competitive in world markets, helping push exports down 4.3 percent through the first 10 months of this year. But China faces even bigger difficulties from a strengthening currency. Trade amounted to 42 percent of its gross domestic product last year, compared with 23 percent for the U.S.

Sudden Rise

A sudden 10 percent rise in the dollar slows Chinese economic growth by almost one percentage point, nearly double the impact on the U.S., according to computer simulations run by economists at Goldman Sachs Group Inc. in New York. “China is more open to trade,” Goldman chief economist Jan Hatzius said in an e-mail. “So the same exchange-rate move results in a bigger GDP effect.”

The yuan has advanced almost 15 percent against a basket of currencies since mid-2014, according to a trade-weighted index compiled by Westpac Strategy Group in Sydney. The rise came at a time when China was already losing competitiveness to countries such as Vietnam and Thailand because of its higher labor costs. 

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During the past 10 years, the yuan’s 26 percent appreciation against the dollar is second only to the Swiss franc’s 31 percent gain among major currencies, according to data compiled by Bloomberg. China’s central bank set the yuan reference rate at 6.4078 per greenback on Dec. 8.

The result of the currency’s recent rise has been slower economic growth. GDP expanded 6.9 percent in the third quarter from a year earlier, its worst performance since early 2009, as the drag from weaker manufacturing and exports offset strength in services and consumption. A stronger currency also hampers China’s efforts to ward off deflation because it puts downward pressure on import prices. Chinese producer prices fell 5.9 percent in October from a year earlier, the 44th consecutive monthly decline.

Fragile Markets

“China will continue to face deflationary pressure, particularly in its manufacturing sector” if the yuan continues to appreciate along with the dollar, Xiao Geng, a professor at the University of Hong Kong, said in an e-mail. He nevertheless expects China will avoid depreciating its currency on concern that such a move would upset fragile domestic financial markets.

Another reason to hold the yuan steady against the greenback: a build-up in dollar-denominated debt by Chinese companies. A cheaper yuan makes it tougher for them to service those obligations. If China does elect to retain its currency regime, it must be prepared for a further broad rise of the yuan in line with the dollar.

Climb to Parity

Allen Sinai, chief executive officer of Decision Economics Inc. in New York, sees the U.S. currency climbing to 140 yen or more and strengthening to parity or better against the euro by the end of next year as the Federal Reserve increases interest rates while other major central banks ease policy. The dollar was at 122.93 yen while the euro stood at $1.0892 as of 5 p.m. Dec. 8 in New York.

Stephen Jen, co-founder of SLJ Macro Partners LLP in London and a former International Monetary Fund economist, said China’s current policy mix “is not consistent or sustainable over time. ”That’s because it’s trying to achieve something akin to what economists call the “Impossible Trinity.” It’s reducing interest rates to boost growth while resisting a depreciation of its currency as money flows out of the country.

“They’re likely to have to devalue,” said Summers, now a professor at Harvard University in Cambridge, Massachusetts. “You can’t have relatively open capital markets, monetary stimulus and a stable currency.”

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