How a stronger dollar boosts trade tensions

December 6, 2010, 8:42 PM UTC

The world has been savaging Ben Bernanke for supposedly destroying the dollar and risking a trade war. But can a stronger greenback do that too?

Why yes, says economist Julian Jessop at Capital Economics. He notes that the dollar’s recent strength against the sagging euro (see right) could complicate the much needed process of straightening out the global imbalances that played such a role in creating the crisis of the past three years, by increasing trade tensions with China.

Euro's sinking feeling

A strong dollar seems sort of like apple pie or Chevrolet or something, but Jessop notes that it could retard rebalancing by increasing the purchasing power of the yuan against the euro.

That makes Chinese exports less competitive in Europe, China’s second-biggest export market after the United States. Moreover, it presumably makes Chinese leaders even less eager to give in to the Tim Geithners of the world and let their currency – also known as the renminbi – rise along with China’s trade balance.

The yuan has gained a little more than 2% against the dollar since China said in June it would let the currency trade in a wider band. But if the dollar keeps rising against the euro, and many wags think it might well as the euro zone threatens to unravel, the appreciation could lose momentum, at the very least.

“A further recovery in the US currency would make it even less likely that China would allow a more rapid appreciation in the renminbi (RMB) against the dollar, as this would imply even bigger gains in the RMB in trade-weighted terms,” Jessop writes.

Renminbi rebound

The dollar-euro-yuan dance is far from the only reason to worry about trade tensions, of course. Jessop puts it third on his list of four reasons we’re likely to see more posturing from both sides in coming years. The other three are:

  1. The U.S. recovery will disappoint.
  2. With Congress still acting stupid and the Fed all backlashed out, protectionism soon will be the only tool left at anyone’s disposal to boost U.S. growth.
  3. Both countries are headed into a landmark political campaign in 2012, which will make policies on both sides of the Pacific even gridlockier, if you can imagine.

This all sounds rather unhopeful, but Jessop adds that he believes the worst-case scenario – a full-fledged trade war with the U.S. leaving the World Trade Organization to slap sanctions on all manner of goods as it deems fit – is not likely.

“The upshot is that China will probably do just enough to prevent all-out trade war, but only after tensions escalate much further,” he writes. “And it will be years before the benefits are felt in a meaningful reduction in imbalances.”

But let’s not get ahead of ourselves. Heading off a trade war is probably good enough for right now.