Wharton's Franklin Allen discusses how recent events could affect the U.S. dollar.

President Donald Trump’s early statements on international trade and currency valuations left many concerned about rocky times ahead: After winning the election, Trump continued to accuse key U.S. trading partners of unfair practices, following up on comments he made during the campaign. By making one of his first acts as president calling the Taiwanese president, Trump seemed to call into question the “one-China” policy (which entails diplomatic, official recognition of China, with an unofficial relationship with Taiwan), in an apparent snub to the mainland.

Mexico and Japan also came in for criticism for alleged manipulation of currency and trade regimes. Even Germany was put in the cross hairs for carrying a perceived trade surplus deemed too large. But more recently, in a phone call with China President Xi Jinping, Trump walked back any threat to abandoning the one-China policy. Then, his meeting with Japan’s Prime Minister Shinzo Abe last week seemed to suggest more cooperation than confrontation. That followed an announcement by Japan’s Government Pension Investment Fund, the world’s biggest, that it would invest in U.S. infrastructure projects that could create hundreds of thousands of American jobs. Still, trade tensions with Mexico and elsewhere remain unresolved.

To better understand how recent events could affect the U.S. dollar and international trade, Knowledge at Wharton spoke with Franklin Allen, an emeritus professor of finance at Wharton who is also a professor of economics and finance at Imperial College in London, where he is executive director of the school’s Brevan Howard Centre for Financial Analysis.

An edited transcript of the conversation follows.

Knowledge at Wharton: I’d like to discuss the U.S. dollar, which could be used as a lens, in some ways, for analyzing some of the key issues in world markets. The value of the dollar, of course, has big implications for world growth, and very importantly, emerging market dollar-denominated debt. Also, many people view the dollar as a bit of a proxy for how the U.S. is performing overall, including the new administration. So, if people lose faith in the dollar, they might sell the dollar off and buy gold, or other currencies, or other investments.

At the same time, if the dollar appreciates too much, that can affect the level of growth here in the U.S. There was a recent Financial Times article that said if the U.S. dollar went up by 10%, that could knock a half percentage point (0.5%) off of GDP growth. There are a lot of pointers in the direction of the dollar getting stronger, such as: economic growth has been pretty strong, and it looks like it’s going to get stronger; especially if the administration passes a stimulus package. They’re also talking about deregulation, lower corporate and personal taxes and corporate tax forgiveness. All these things could put upward pressure on the dollar. The stock market has been doing well — that seems to draw money in and increase the dollar. And of course, the Fed has been talking about wanting to raise interest rates — that makes for a stronger dollar.

On the other side are the politics. President Trump has been talking about an interest in a weaker dollar. He is also saber-rattling about trade with some of the U.S.’s major trading partners; Mexico, China, Japan, Germany and other euro countries.

Given all of that, there’s a lot of contradictory stuff. What’s your view of the landscape? How important is it to look at the dollar, to figure out what’s happening in the world, and what’s likely to happen going forward?

Franklin Allen: I think it’s fairly important. I don’t think it’s hugely important, but it’s certainly one of the important things. Probably, the main driver is the difference in interest rates around the world, for the short run, at least. And, how things like a stimulus package, and so on, will play into that. If [the U.S.] does pass a big stimulus package, then my guess is that the Fed will raise rates faster than they otherwise would have done, and that will have an effect. We’ll see whether that gets passed; what the timing of that is, how the expectations for that play out.

The other thing, which I think is important, is what happens in the other countries, in terms of interest rates. In particular, in the Eurozone; whether that continues to stay where it is, or whether the growth that started to emerge leads to some ending of the quantitative easing, and raising of rates going forward. All of those, I think, will be very important for where the dollar ends up.

I think the trade policy of Trump will also play an important role. We’ve seen, clearly, some aggressive moves against Mexico, in particular, but also towards Germany, and to a lesser extent, maybe Japan. And then, of course, the big one is China. That’s been a little bit on the back burner, with everything that happened after he was elected; in particular, the call from the president of Taiwan, and the issue about the “one-China” policy, and whether it would be continued.

“The notion that China is manipulating it is somewhat valid, but they’re manipulating to keep it valuable, rather than to keep it undervalued.”

Hopefully, the talk [February 9] between President Xi and President Trump will mean that now that issue is off the table and we can focus on trade. I think there are lots of things going on, as your introduction indicated. But I would stress, most of all, the interest rate movements, and also the trade movements.

Knowledge at Wharton: One key thing is that if the dollar were to appreciate quite a bit, then there are a lot of emerging market countries out there that have a lot of dollar-denominated debt. We know that in the past, the Asian financial crisis of the late 1990s, and the Latin American crisis of the early 1980s — the dollar had a role in those problems. They had a lot of dollar-denominated debt, which suddenly became very expensive when they had big devaluations of their currencies. Could you talk about the risks in emerging markets right now?

Allen: I think that potentially, is something to worry about. The key issue is the extent to which they have dollar-denominated income from exports, and various other sources, to offset their dollar debt. I think it’s the net positions, rather than the gross positions, that are important there.

A country like South Korea, I think it’s less of a problem than some of the other countries which are borrowing in dollars…. I would say there’s wide variation in that. But I think that’s something people need to keep an eye on over the next year or two.

Knowledge at Wharton: We’ve seen that President Trump is very concerned about trade with Mexico…. There’s talk of putting some kind of tax, or tariff, on imports. I’m wondering what effect this would have, both on Mexico and the U.S., and as a chilling effect on trade in general? Part of what I’ve read suggests that it won’t be very effective, because the dollar may just adjust in a way that would have a zero-net effect in the long run.

Allen: That’s what people have argued, but that’s in an ideal world that it would adjust. Whether or not that will happen in practice, I think, is still something that we don’t have a good sense of. I think if [the Trump administration does] something like that with Mexico, then it will potentially cause big problems because so much of world trade now is on supply chains. Really, a lot of what’s happening in Mexico is supply chains. If they get disrupted, then people can be very reluctant to invest in those kinds of things again. That could potentially have a very big effect.

I guess it’s tied up with how they want to renegotiate the NAFTA agreement; and I think we still don’t have too much idea what exactly their tactics on that one are going to be. There’s also the [border] wall, and paying for the wall, and all those issues bubbling away underneath some of these things. So, I think it’s going to be a while before we know how that plays out. But it is potentially disruptive, not just for Mexico, but for many other countries where people are using them as part of a supply chain.

Knowledge at Wharton: China was a real whipping-boy for President Trump during the campaign. He talked about China’s currency being undervalued. Some analysts and critics said, well, that was true years ago, but it actually isn’t the case now. Although it is true, I think, that the Chinese currency has been depreciating somewhat against the dollar more recently, but probably for good, fundamental reasons. Can you talk about your view of how accurate the relationship between the dollar and China’s currency is now, and how much merit there is to what the administration has been talking about, regarding China?

“The euro is not controlled by Germany. If they could do anything, they would want the ECB to raise rates [and thus the value of the euro].”

Allen: My own view on the RMB-dollar exchange rate is that it depends a great deal on the capital account flows, as well as the current account flows. I think too much of the discussion focuses on the current account flows, and the deficit that the U.S. has with China. But what we’ve seen, as your question indicates, is that in fact in recent months there has been a weakening of the RMB as the dollar strengthened. So, the notion that they’re manipulating it is somewhat valid, but they’re manipulating to keep it valuable, rather than to keep it undervalued. I think that is, to a large extent, because of capital flows coming out of China. As long as that continues, it’s likely to be weak.

What we have to see is how capital account convertibility plays out in China. They’ve said they’ll do it, but the time frame is very important. And, as long as there’s money coming out in the kinds of quantities that there are, I think they’ll be reluctant to do it any time soon. So, my own view is that that’s the big issue on the RMB-dollar exchange rate.

Knowledge at Wharton: Also, with Japan, there’s been some jawboning by President Trump about the currency differences. And then, perhaps coincidentally, there was an announcement by Japan that it was willing to make certain investments in the U.S. that would create hundreds of thousands of jobs. What are the merits of the argument that Japan is still — I say ‘still,’ because this was an argument that goes back to the 1980s — manipulating its currency against the U.S. dollar?

Allen: They do intervene more than most countries in the foreign exchange market, but I think this is more to smooth the movements, rather than to have a fundamental effect. The one major achievement of Abenomics was to move the exchange rate so that the yen did effectively devalue against the dollar. But I think that they really are trying to stimulate the economy, and that this was a side effect, rather than the main reason for doing it.

I would say that they aren’t manipulating their currency, and that the charges that the Trump team is making are not particularly valid, with respect to Japan.

Knowledge at Wharton: I think back when Japan first instituted some of those changes, under Abenomics, that the International Monetary Fund (IMF) actually gave them the blessing to go ahead and do that.

Allen: Yes. I think the view was, they’ve had such a bad time for such a long time, that we should give them a free pass on that. But it’s an interesting one, because Brexit basically does the same thing for the pound. The pound has devalued substantially, and the economy’s now doing quite well — partly as a result of that, I think. So, these movements in exchange rates are driven by a wide range of things, and I think that the notion that countries are doing these things on purpose is probably not a valid one, in most cases.

Knowledge at Wharton: The final case I wanted to chat about is Germany. I didn’t expect to be talking about Germany until President Trump came out and accused them of undervaluing their currency, which, of course, is the euro, which, of course, most of the continent uses. There have been criticisms that Germany has benefited from a relatively low euro, because it’s a big exporter, one of the biggest in the world. And so, if it had its own currency, that currency would have gone up a lot. And that would have balanced out its trade with the rest of the world. But also, Germany has been criticized for not spending more within the EU to take some of those gains, and to spread it around, as it were, and try to stimulate the rest of the EU.

But in any case, Germany doesn’t totally control the euro. So, what’s going on when you actually go head-on against Germany, and accuse it of manipulating its currency?

Allen: I think this is one of the most interesting questions — not just in this aspect, but also, of course, if you look at some of the other things that the Trump administration has been stressing. Like, spending at least 2% of GDP on defense for NATO members. Germany is also one of the biggest violators of that. They’re having a tremendous amount of pressure put on them, I would say.

In terms of the economic aspect, I guess I would be more sympathetic to them in the sense that the euro is not controlled by them. That’s controlled by the European Central Bank (ECB). And I would think, if they could do anything, they would want the ECB to raise rates. They’ve been complaining bitterly about the penalty that German savers have been facing because of the low interest rates the ECB is setting. And, of course, if they were to raise interest rates, the euro would probably appreciate significantly. So, I think it’s a misplaced charge.

My own view on, should they be spending more? I guess that’s a sort of a macroeconomic view, based on inflexible prices, and whereas there’s some merit to that in the short run, in the long run, I don’t think it’s particularly valid. The one thing we know is that Germany has been running surpluses, in the long run, for many decades now. They’re incredibly competitive. People love their goods. And so, whatever the exchange rate is, they seem to do well. So, I think in this case, the issues raised by Trump are not particularly valid.

Knowledge at Wharton: What do you think is going to happen to the dollar over the next year or two, given pressures I mentioned, at the outset, that suggest that the dollar would go up, at least somewhat? And then, the opposite pressures, at least so far, of the new administration, suggesting they want a softer dollar, and also kind of saber-rattling against our trading partners, when it comes to the currency, in the hopes of improving the U.S. trade position.

Allen: I think a lot of things are already priced in, that you’ve discussed. The one thing that we do definitely know is that forecasting exchange rates is one of the most difficult things to do. And there are not many people that can do it very well, and I’m certainly not one of them. I wouldn’t be surprised if the dollar strengthened, but I also wouldn’t be surprised if it weakened. I think there’s just so many things that can happen, in terms of the Trump program, that can make it move either way. There are some trade issues that we haven’t seen play out very much yet, particularly with China.

“Exporters, like Boeing, and so forth, are going to do wonderfully well. And the importers, like Walmart, are going to do pretty badly, in terms of their taxes.”

But there are also a number of other things, like security issues, and so on, and how Congress reacts. What they do about these border taxes that we talked about, and so forth. There are just so many things. It would be very difficult to project what’s going to happen.

Knowledge at Wharton: Is there’s anything else you want to bring up in connection with all of this?

Allen: This issue about the border tax — of making exports non-taxable, and imports non-deductible — is potentially a big thing. Republicans seem to be pushing that hard in Congress, but it’s not quite clear what Trump thinks about it. But that could drastically change a number of things. One would be the dollar, but also, the relative positioning of firms will change quite a lot, I think, if anything like that happens. We’ll see whether it does. How the World Trade Organization will react to that is also up in the air, I would say. But I think that’s a big issue.

Knowledge at Wharton: When you say it could bring big changes for firms, could you describe, just in broad strokes, what some of them are?

Allen: Well, the exporters, like Boeing, and so forth, are going to do wonderfully well. And the importers, like Walmart, are going to do pretty badly, in terms of their taxes. So, that’s one aspect. Whether or not it will change how they proceed, in terms of importing less and exporting more, I think, is an open question. I’m not sure how much of the effect there will be.