Note to U.S. Senate: Here’s What Happens When Dollar Rises 25%

  • Previous gains curbed inflation as Fed kept rates near zero
  • Dollar strength may have spurred bouts of yuan instability

Deciphering Mnuchin's Message on the U.S. Dollar

So what happens when the greenback climbs by 25 percent? That was a question pitched to U.S. Treasury-secretary nominee Steven Mnuchin -- a product of concern about potential protectionist actions in the Trump administration.

The background: Economists have penciled in dollar appreciation of as much as a quarter as an offset to the imposition of a U.S. border tax along the lines proposed by some Republican lawmakers. Mnuchin, responding to written questions following his Senate confirmation hearing last week, didn’t detail the effects of such a gain, other than to say that sometimes there are “negative short-term implications” for the economy.

Turns out there’s no need to deal with hypotheticals. Less than three years back, the U.S. currency jumped 26 percent in about eight months. While the current-account deficit stayed around the mid-2 percent range relative to gross domestic product, the dollar’s strength dragged down American exports and inflation slowed. That helped reduce the Federal Reserve’s appetite for normalizing interest rates.

While some analysts have warned of an emerging-market crisis should the dollar climb further -- because that would make it costlier for developing countries to service debt in the U.S. currency -- it’s hard to point to any dollar-sparked crisis in recent years. Except, maybe, when it comes to China, where policy makers faced bouts of instability in managing their currency.

“China was the biggest beneficiary of the dollar weakness,” said Kevin Lai, chief economist for Asia excluding Japan at Daiwa Capital Markets in Hong Kong. “Naturally it has been the biggest loser of its strength -- it’s payback time.”

As the greenback’s shift toward strength became clear in 2015, Chinese policy makers began to cope with surging outflows of capital, some of it to pay down dollar debt. Things got a lot hairier when authorities executed a mini-devaluation that August. Capital outflows from China accelerated in late 2016 as the yuan suffered its worst year of losses against the U.S. dollar since 1994, declining 6.5 percent. 

“Given the yuan’s semi-peg to the dollar, a large movement in the dollar, no matter toward the strong or weak side, will cause problems for China,” said Zhao Yang, Hong Kong-based chief China economist at Nomura Holdings Inc.

Sentiment remains fragile toward the yuan as analysts see the dollar remaining strong on the back of President Donald Trump’s planned policy mix of tax cuts, regulatory easing and infrastructure investment to boost growth. If that plays out, it could mean higher U.S. interest rates, which would support the dollar at the expense of other currencies.

“That’s why China’s policy makers need to manage expectations carefully,” while keeping capital controls as an option, said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong.

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