The Yuan's Problem With the Dollar

The arrival of Chinese Vice President Xi Jinping in the U.S. next week refocuses attention on the yuan-dollar exchange rate.

Financial markets are pessimistic about the outlook for yuan appreciation. Expectations for the year ahead are for 2%-3% nominal gains against the dollar in 2012, compared with 5.1% in 2011. With China's exporters facing a tough year, and falling inflation also weakening the case for yuan appreciation, such muted expectations make sense.

But there is also another variable at work, and one which is outside the control of Beijing: the value of the dollar.

If the dollar is flat against the euro and the yuan gains 5% against the dollar, it also gains 5% against the euro. But if the dollar gains 5% against the euro and the yuan gains 5% against the dollar, the yuan gains more than 10% against the euro.

In short, if a stronger-than-expected recovery in the U.S. combined with continued uncertainty about the future of the euro means the dollar strengthens, it will be more difficult for China to chalk up even limited bilateral gains without having a serious impact on competitiveness. Pessimistic predictions about the outlook for yuan appreciation could very well come true.

But if expectations of continued loose monetary policy in the U.S. and a brighter outlook for the euro push the dollar down, the pressure will be in the opposite direction. A falling dollar opens space for bilateral appreciation without denting competitiveness too much. A weak dollar also raises the cost of the commodities that China imports, so allowing the yuan to follow it down means importing inflationary pressure.

The U.S. will take the opportunity of Mr. Xi's trip to bend his ear on the need for sustained appreciation of the Chinese currency. But at least some drivers of the yuan dollar exchange rate can be found closer to home.

Source: http://online.wsj.com/article/SB10001424052970204369404577205960431147348.html?mod=WSJ_Heard_LEFTTopNews