The RMB has appreciated by about 7% against one of China’s major trading partners this year. Not the US, obviously. But that doesn’t mean that China is not exposed to moves in the dollar-euro, or the dollar-yen.
Indeed, right now, it looks like the RMB will move far more against the euro than against the dollar in 2005, even if China makes some small changes in the dollar-RMB peg over the summer.
There are plenty of reasons for the dollar’s rally v. the euro — the upcoming French referendum on the new EU constitution, obvious signs that growth is slowing in Europe, rising policy interest rates in the US and constant policy rates in Europe, and the unwinding of some dollar funded carry trades. For now, “cyclical” concerns trump “structural concerns” about the US trade and current account deficit. Fair enough. Credit is owned where credit is due: so far, Stephen “Current account deficits don’t matter” Jen has been directionally right. He also thinks fair value for the euro dollar is closer to 1.1 than to 1.25 (Jen’s longstanding view), so he thinks the dollar has room to rise a lot further …
The dollar’s rally — and low long-term US interest rates — still worries me. I would be more comfortable if the dollar was depreciating against non-European currencies and holding constant against the euro, widening the base dollar depreciation. And yes, I also would prefer to see a slow rise in long-term US rates.
The world seems to be slipping back towards the growth pattern that everyone is most familiar with — growth driven fundamentally by surging US demand, supported by rising US real estate prices. China contributed substantially to global demand growth too in 2003 and 2004, particularly in some commodity markets. But Chinese import growth has slowed this year. Right now, China, like everyone else, depends on the US consumer.
What’s wrong with this? This pattern of growth presumes growing global imbalances — i.e. an expanding US trade deficit. And it will result in growing domestic imbalances in the US. A real-estate centric economy will become more real-estate centric. If the dollar rally continues, the market incentives to invest in the US tradables sector will fall — yet that export capacity is what the United States needs to grow out of its trade deficit by growing its exports (It should be noted that the dollar has depreciated against the Brazilian real and Korean won this year, even as it has appreciated against the Euro, limiting the dollar’s overall appreciation).
In the short-run, there are advantages to continuing the current pattern of growth. It is far easier for the growing sectors in the world economy — real-estate in the US, exports in China — to keep on growing than to find a new basis for growth. But it also adds to the risk of a hard landing further down the line. To me, the soft landing scenario requires market pressures to slowly emerge to change, gradually, the composition of US growth: a falling dollar increases incentives to export, and to invest in export sectors; rising interest rates reduced the incentive to bet on rising housing prices, and make it harder to cash out home equity. The reverse would happen abroad: slowing demand growth in the US and the drag of a weak dollar would prompt other countries to focus on stimulating domestic consumption. Alas, that, by and large, hasn’t happened.