US dollar strength

Is the U.S. Dollar Too Strong For Its Own Good?

It’s been said that when America sneezes, the whole world catches a cold. Now, with China’s growing macroeconomic influence, its financial ailments are becoming contagious as well.

Recently, China’s central bank, the People’s Bank of China, made a change to the yuan’s peg to the U.S. dollar, essentially allowing the Chinese currency’s value to be more influenced by the market. This supplemented the depreciation that roiled the markets last year over China’s decelerating GDP growth, pushing the yuan from 6.2180 CNY/USD ($1 = ¥6.2180) in January 2015 to 6.5779 today.

So what does this mean?

As the dollar strengthens and the yuan weakens, U.S. exports will become more expensive, yielding less foreign revenue for U.S. multinational corporations. Meanwhile, Chinese exports will become cheaper, yielding higher revenues for Chinese companies.

For clarity, let’s look at an example.

Suppose an American company sells a product in China for 700 yuan. At January 2015’s average exchange rate, this amount converted to $112.57. However, after a year of currency swings, 700 yuan equates to $106.42 today. So, the U.S. company that wants to sell in China will either need to eat this currency headwind or increase their retail price to maintain currency-adjusted margins, risking sales among cost-conscious consumers.

On the other hand, imagine a Chinese firm that sells a similar product for $112.57 in the U.S. At January 2015’s average exchange rate, this amount converted to 700 yuan. But today, this equates to 740 yuan. The Chinese firm can either collect the fruits of this currency tailwind or lower its retail price in the U.S., undercutting its U.S. competitors while still earning the same revenue it was getting a year ago.

Extrapolating this currency headwind to the billions of dollars seen in annual U.S. exports, it’s easy to visualize the harm a strong dollar poses for corporate operations. Ultimately, these lower revenues will lead to U.S. job cuts and negatively impact economic growth, even while American consumers benefit from cheaper import prices.

Another consequence of fluctuating exchange rates is the flight of capital from nations with weak currencies to nations with strong currencies. In China’s case, investors are converting in excess of a trillion yuan into dollars in an effort to stem their decreased buying power. But as yuan flee from China, the amount of capital available to invest in the world’s most populous country is reduced, exacerbating its slowing growth and calling for the PBOC to increase stimulus efforts, which will only further depreciate the yuan.

If the PBOC further lowers interest rates, yet more capital will flee in search of stronger currencies, fueling this vicious cycle. On the other hand, if the PBOC increases rates in an effort to stem the yuan’s depreciation, then debt-ridden Chinese companies risk default, promoting joblessness and slower economic growth.

And let’s not forget about other major currencies like the euro, Japanese yen, Brazilian real, and Russian ruble. They could ignite a currency war as their values fluctuate, diminishing tourism from these countries to the U.S. for fear of unfavorable exchange rates.

In fact, the European Central Bank is heavily weighing further stimulus measures, which will weaken the euro and add to U.S. corporate currency headwinds. This follows last week’s announcement that the Bank of Japan will adopt negative interest rates to spur lending.

Looking toward the Federal Reserve’s March FOMC meeting, many authorities expect them to stand pat after announcing the first interest rate increase in nine years last December. With currency headwinds amid persistently low inflation levels, the healthiest treatment may be a dovish signal such as deferring a rate hike to curtail the U.S. dollar’s strength.

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