Pedestrians cross an intersection in front of a Marks & Spencer Group Plc. store in the central business district of Hong Kong, China, on Thursday, July 9, 2015. Photographer: Jerome Favre/Bloomberg

The value of the Chinese currency dropped by 4.4 percent this week, the biggest devaluation in decades. The move spooked global markets and sparked an angry reaction on Capitol Hill, with politicians on both the left and right accusing China of returning to its old currency-manipulating ways in order to boost its flagging exports and economy.

The Chinese devaluation effectively makes China's exports cheaper, and it has put pressure on the U.S. dollar to rise. The threat to the U.S. is that a stronger dollar could dampen American exports and potentially disrupt a nascent economic recovery.

But the challenge that China's devaluation poses to the American economy is just one part of a much bigger global problem. And that problem is weak economies -- some long-running like in Europe and Japan, others more recent like in China and Brazil -- that are pushing governments to take new steps to speed up growth.

Those steps have the effect of making those countries' currencies and their exports cheaper, and the U.S. dollar and American exports more expensive. It is one of the most important dynamics in the world economy right now.

Since hitting a low point in mid-2011, the U.S. dollar has risen by about a third against a basket of global currencies; in just the last year, it is up 20 percent. Patrick Chovanec, chief strategist at Silvercrest Asset Management, says the dollar’s strength already shaved around two percentage points off U.S. economic growth in the first quarter of this year.

And the signs suggest this trend will continue. Chovanec said he expects China's currency devaluation to have more of the same dampening effect on U.S. growth this year.

The dollar has risen so much in the last year in part due to massive programs in Europe and Japan aimed at stimulating their sluggish economies. After being embroiled in a debt crisis for years, the European Union has been left with unemployment over 10 percent, an embattled corporate sector and a shaky banking system. Japan, meanwhile, has recorded years of slow growth, has alarming public debt levels and is perpetually on the brink of deflation.

Given these difficulties, central banks in both Europe and Japan have embarked on massive bond-buying programs, known as quantitative easing, to stimulate growth. This program helped the Japanese economy soar 3.9 percent in the first quarter of the year, compared with 3 percent in the U.S. The countries that use the Euro grew by 1.2 percent in the second quarter, according to figures released Friday.

Due partly to these quantitative easing programs, the value of the yen and the Euro have fallen by more than 20 percent against the dollar in the past year. Although these programs target domestic interest rates in an effort to boost investment and the economy, they have a secondary effect on a country's currency and exports. By printing money to stimulate their own economies, Europe and Japan have also made their currencies cheaper, boosting their exports and putting more competitive pressure on U.S. exporters.

 

 




Economists caution that these stimulus programs are different from China's recent move in many ways; for one thing, Europe and Japan's efforts focus on their own economies, while China's currency devaluation explicitly targets export markets in other countries. Yet, in the end, the consequence is similar: weaker currencies in other countries, and a stronger U.S. dollar that weighs on American exports.

Beyond stimulus programs, another important factor that has strengthened the dollar is monetary policy in the U.S.

The relative strength of the U.S. economy has led the Federal Reserve to talk about raising interest rates, perhaps as soon as September. As soon as the Fed started talking about an interest rate hike, investors started pulling their money out of currencies around the world and putting it into the dollar. That's because higher interest rates will mean that money invested in the dollar gets a bigger return.

That flood of money out of other currencies and into the dollar has left other currencies around the world much weaker, says Amit Khandelwal, professor of finance and economics at Columbia Business School.

China’s move to devalue its currency came partly in response to these broader global pressures. The Chinese currency is partially pegged to the U.S. dollar. As the value of the U.S. dollar rose last year, the Chinese yuan stayed largely in step with it, as the last chart above shows. That left the yuan looking overvalued compared to other global currencies, including those of other Asian exporters. Nick Lardy, a senior fellow at the Peterson Institute for International Economics, says the market has been putting downward pressure on the value of the Chinese yuan for many months.

All this points to a much bigger and thornier global problem: A broader lack of consumer demand globally, and a general race to the bottom as countries compete for scarce consumers in export markets.

Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities, points to concerns about growth all over the world, in China, Europe and Japan, as well as emerging economies like Brazil. “And in the U.S., we’re doing better than the rest, but it’s far from gangbusters here as well,” he says.

“Everybody would love to boost their net exports, but everybody can’t do that at the same time, unless we find other planets to buy our stuff,” says Bernstein. “China is making a play here to boost that part of their economy, and it will come at the expense of those whose currencies appreciate relative to theirs, which thus far has meant us.”

Chovanec agrees that China's move is aimed one of the last big consumer markets in the world -- America. China is looking to the U.S. to continue to over-consume and drive global demand, as we have in past decades by taking on lots of debt. "And that’s not sustainable. It’s not sustainable for us, and it’s not sustainable for them,” Chovanec says.

“I understand the temptation to try to do that, but it really is a situation where everybody doing it makes everyone worse off,” Chovanec says.

See also:

-China’s central bank slows yuan’s descent, brings calm to markets

-China’s devaluation of yuan prompts outcry from U.S. politicians on both sides

-What China’s surprise currency devaluation means for its economy and the world