A strong currency has created headwinds for the U.S. economy through a range of channels. Latest actions of the Chinese central bank will intensify the negative impact by fostering more dollar appreciation. The U.S. already runs a significant trade deficit with China, and a 1.9 percent yuan devaluation announced Tuesday will further exacerbate it.
A stronger dollar weighs on U.S. growth through weaker exports, cheaper imports, devaluation of overseas profits and a sharp increase in domestic labor costs in non-dollar terms. It creates a more restrictive economic policy, thereby accomplishing the same goal as higher interest rates. In short, currency appreciation is doing at least some of the heavy lifting for policy makers, and could therefore mitigate the need for rate normalization to occur sooner rather than later. The September liftoff will be jeopardized if dollar strength continues.
The widening trade imbalance is bluntly demonstrated in the first chart. From 1994 to present, U.S. imports from China have increased to a much greater degree than U.S. exports to China, in part because the Chinese currency remained at artificially weak levels for much of the time.
The impact is even larger than the bilateral trade data suggest, due to the competitive disadvantage in third market economies — for example, as U.S. and Chinese tire producers compete for market share in Europe.
During the past year, as the dollar appreciated substantially relative to many other trading partners, a tight linkage with the yuan resulted in an unwelcomed strengthening of the Chinese currency, as well. This afforded an advantage to major competitors of the Chinese export sector, thereby crimping demand for Chinese-produced goods.
The Chinese devaluation attempts to correct this, or at least start the process. The net effect will not only worsen the trade imbalance between the U.S. and China, however, it will also deal a further blow to U.S. exporters more broadly. The drag on U.S. growth from a deteriorating net export position will intensify.
To more fully understand the cumulative impact of currency moves within the overall trade landscape, economists analyze trade-weighted currency values.
The Federal Reserve produces a broad trade-weighted index, weighting bilateral exchange rates of major trade partners according to the volume of trade. Hence, a currency move with a large trading partner will have a proportionally larger impact on the index.
The broad trade-weighted index, shown in the second chart, comprises 26 currencies, the five largest being the Chinese yuan (weighting factor = 21 percent), the euro (16 percent), the Canadian dollar (13 percent), the Mexican peso (12 percent) and the Japanese yen (7 percent). The dollar’s strengthening relative to each during the past year has been as follows: yuan (3 percent), euro (21 percent), Canadian dollar (20 percent), peso (25 percent) and yen (22 percent).
Therefore, in terms of impact on the trade-weighted dollar, the move in the yuan remains the smallest by far. Even so, it magnifies an already severe problem — and could intensify if China chooses to pursue a devaluation similar in magnitude to the market-determined results for the other trade partners.
Carl J. Riccadonna is the Chief U.S. Economist at Bloomberg Intelligence.