Dec 15, 2016 05:04 PM

Opinion: Strong Dollar Could Spell Problems for Other Currencies

The election of Donald Trump has made the dollar stronger than ever, as the euro has moved toward parity with the dollar, and the yen and sterling have also weakened. The problem right now is not that the yuan is weak, but that the U.S. dollar is strong.

Why is the dollar strengthening so much, and what does this mean for RMB internationalization?

The dollar is strengthening not just because the Fed is raising interest rates. The rise in interest rates is a catch-up process because there are more than enough signs that the U.S. economy is beginning to take off, and employment numbers are already reaching full employment status. Hence, if Trump carries out tight immigration policy and crack down on illegal workers, wage inflation is more or less inevitable.

The second reason the U.S. economy is improving is that what has held U.S. productivity back is infrastructure, which has been stalled by domestic politics. Trump's promise to increase infrastructure would improve U.S. corporate profitability. Imagine if the U.S. were linked completely by Shinkanshen fast rail financed by willing Abenomics. The export of yen to finance infrastructure to the U.S. would help keep the yen weak and help keep U.S. long-term bonds low — an ideal situation for both parties. China can also finance U.S. infrastructure.

Thirdly, in the past, U.S. Presidents Barack Obama and George W. Bush could not implement many policies because the U.S. House and the Senate were controlled by the opposition party. Since the Republican Party now controls the presidency plus the Senate and House, they will ensure that the economy recovers with good jobs quickly in order to ensure a second Trump term. Failure to act now would risk stalemate if the Democrats were to recover control of the House, Senate or both in two years.

Fourthly, since Trump's policies are all inflationary, the combination of corporate profits rising and inflation eroding the U.S. debt overhang means that global savings will rush to the U.S. This is because the fundamentals of investing in Europe, Japan and emerging markets are weak. Europe will face political change in Italy, sorting out problem banks and huge migration threats. Japan is aging, and a number of emerging markets are facing serious political transitions in Brazil, Venezuela and South Africa, and continuing unrest in the Middle East. Whenever geopolitical risks rise, money flows back to the dollar.

Fifthly, there is a regulatory reason why the dollar is strong. If you exclude intra-European trade, most cross-border trade and investment is conducted in U.S. dollars. The recent regulatory reforms increased bank capital, liquidity and aversion to credit risks, so the major European, U.S. and Japanese banks shun lending to emerging markets and return to lending mostly to advanced markets. This explains why credit and exchange rate spreads to almost all emerging markets are widening, costing more to transact in cross-border trade and investments.

I recently convened a high-level symposium on "One Belt One Road" (OBOR) strategic issues for China and Malaysia in Penang, Malaysia. China is today Malaysia's leading trading partner, and relations are excellent after the recent visit of the Malaysian prime minister to China. The purpose of the symposium was to look at practical ways to implement the OBOR goals.

It turned out that the yuan-ringgit bilateral relationship is critical to the future of not just bilateral trade, but also symptomatic of the dollar role in China-emerging market trade and investments.

When both the yuan and ringgit are stable (plus or minus 1% within three months) against the U.S. dollar, transaction costs and risk spreads are very low, facilitating trade and investments. But under a strong-dollar environment, exchange rate flexibility will widen not just the exchange spread, but also the credit spread in a nonlinear manner. Simplistically, when the volatility band expands to, say, plus or minus 3%, both sides may pay 4% to 5% or more on transaction costs. The reason is most cross-border trade is quoted in U.S. dollars, so both the importer and exporter must engage in conversion from local currency to U.S. dollars. Having a third currency makes life complicated, since with rising interest rates, funding in dollars is more expensive, and for many small and medium enterprises, credit in dollars is typically much harder to obtain.

Notice that if the bilateral trade is conducted in yuan or ringgit, there would be much less costs involved. But the standard practice is that current accounting systems are written for cross-border trade in dollars. It will take major efforts to persuade importers and exports to switch to bilateral currency usage without dollars.

Even if traders are willing to use yuan or local currencies for bilateral trade, there are also investment costs to consider. Importers or exporters holding non-dollar currencies will have to consider how to invest the short-term funds in currencies they hold. The arithmetic of investing in U.S. dollars is easy. If the local currency return on a balanced portfolio of equity/bonds/cash in local currency is, say, 10% per annum, and the estimated dollar return in U.S. equity/bonds/cash in the U.S. is 7.5% (JPMorgan estimates), then any change in dollar/local currency depreciation larger than 2.5% will cause an inflow into dollars. Consequently, euro, yen and emerging-market-economy currencies have already moved more than 2.5% against the dollar.

A strong dollar environment typically tightens global credit for emerging markets. The 1980s Latin American crisis and 1990s Asian financial crisis were caused by strong dollar situation, relieved only when the Fed began to loosen credit.

The reality in the international monetary system is that it lacks a global central bank. If the Fed acts only for U.S. interests, the spillover of higher Fed interest rates and larger capital inflows into a stronger dollar will have global implications, not least for yuan internationalization. In other words, there is no unified global monetary policy, just as the euro crisis showed that the possibility of unified global (let alone regional) fiscal policy is zero.

Under such circumstances and uncertainties, global investors flock to what appears to be a certainty — a stronger U.S. dollar. But that is not without its risks, as nothing goes up forever. Hence the construction of yuan internationalization and a new international monetary order based on the Special Drawing Rights or the equivalent is absolutely a move in the right direction.

How to get there, and persuading the U.S. to agree that the strong dollar is a mutual problem, is another story.

The author is a distinguished fellow of Asia Global Institute, The University of Hong Kong; chief adviser to the China Banking Regulatory Commission; and a former chairman of the Hong Kong Securities and Futures Commission.

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