China Key to Global Realignment If Dollar Keeps Surging

For the first time this century, the dollar is poised for a multiyear surge against the rest of the world’s currencies. For now, that is due to the divergent economies and monetary policies of the U.S. and eurozone.

But if this global realignment eventually fuels the kind of economic and political tensions that arose in the past, the endgame solution may lie with China.

The risk, notes C. Fred Bergsten, director emeritus of the Peterson Institute for International Economics, is that a relentlessly advancing dollar could revive the global demand/supply imbalance that stoked the 2008 financial crisis. In the years before that cataclysm, emerging-market producers exploited their cheaper currencies to sell a glut of unsold products to dollar-rich American consumers, who paid for them with debt funded by the excess savings of those same, underconsuming smaller economies. It showed up in Asia’s gaping current-account surpluses and in a U.S. deficit that reached 6% of GDP.

The biggest contributor to that imbalance was China, whose growth was hitched – via an undervalued yuan – to the U.S. consumption machine. A symbiotic U.S.-China relationship emerged and then morphed into a co-dependent one that disrupted the entire global economy. Harvard professor Niall Ferguson dubbed it “Chimerica.”

China has since allowed the yuan’s value to appreciate and the current-account imbalances have narrowed. But the world’s second-largest economy remains unhealthily dependent on manufacturing exports and on an investment cycle that is perpetually being doubled down in search of ever-thinner returns. And China still carefully manages its currency’s value. A much longed-for Chinese transition to a consumer-led economy hasn’t happened, at least not to the extent needed.

This is a recipe for reviving global imbalances, especially if Beijing caves in to demands for a weaker yuan from exporters now competing with other emerging-market producers that are selling in newly cheapened currencies. While a strengthening dollar brings global benefits, not least in helping Europe export out of its malaise, it could also stir up America’s influential anti-China exporter lobby. With a presidential election and two contentious trade deals on the horizon, “currency manipulation” is becoming a buzzword again in Washington.

The WSJ Dollar Index is up 32% since a postcrisis low in 2011. That is consistent with an improving U.S. economy and expectations for Federal Reserve rate increases while the European Central Bank and other monetary authorities ease monetary conditions to fight economic stagnation. For now, “exchange rates are doing what they are supposed to do” in acting as “shock absorbers” to the eurozone and other struggling economies, says Tufts University professor Michael Klein. “In general, exchange rates are an outcome, not a cause.”

But there’s a point when exchange rates become politically distorting in their own right – as in the 1980s, when trade-weighted dollar indexes doubled in value. With, many analysts predicting a further 30%-to-40% upside for the dollar, we might again reach that point.

“A lot of people say this is the U.S. contribution to the global economy—share the wealth, help the allies out of their basement but politics can intrude on that,” says Mr. Bergsten. He believes there is a strong possibility that the U.S. government, perhaps under the next president, will seek a major currency realignment in coordination with other governments. Others, such as Stanford University professor John Taylor, are calling for a new international monetary policy compact. These were ideas that were virtually unthinkable over three decades in which inflation-targeting and laissez faire exchange rates were the mantra. The challenge lies in implementing them.

The Group of Seven industrialized nations, which signed the famous 1985 Plaza Accord to depreciate the dollar, is now relegated to a minor role behind the Group of 20 in international policy setting. The Group of 20’s elevation was an acknowledgment that emerging-market voices were now needed on such matters. But it would be unwieldy to involve all 20 members in currency policy. And what could, say, Argentina constructively add?

On the other hand, any effective agreement must involve China. And that’s where the endgame gets interesting.

For China to cooperate with Western governments in weakening the dollar, it would need to bring its monetary system in line with theirs, opening the capital account, liberalizing interest rates, making the yuan fully convertible.

Those are changes Beijing wants to implement, but they pose an enormous challenge because introducing them unilaterally would unleash sweeping capital flows and financial volatility, which could provoke a Chinese banking crisis and strip manufacturers of their competitive advantage.

The solution: a multilateral approach. A new coordinated exchange-rate pact, which would steer money flows more equally around the world, could be the cover China needs to overhaul its monetary system and in turn remove one a major cause of the global imbalances problem.

All this is hypothetical, of course. But it does demonstrate that a long-running surge in the dollar could profoundly affect the shape of the global financial system.

– Follow Michael J. Casey on Twitter: @mikejcasey.

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