A once-in-a-generation rally in the value of the US dollar was witnessed recently, thus threatening an already sluggish global economy and exacerbating concerns about inflation.
As per the current developments, the currency stays on the defensive side, amid the US Federal Reserve’s frequent raising of its benchmark interest rates throughout 2022.
Because the dollar is the dominant currency in international trade and banking, its movements have a significant impact. The food and gasoline shortages in Sri Lanka, Europe’s record inflation, and Japan’s ballooning trade deficit reflect the currency’s strength.
The ICE US Dollar Index, which compares the dollar’s value to a basket of the country’s main trading partners, has increased by more than 14% in 2022 alone, putting it on pace to have its most extraordinary year since its inception in 1985. The euro, the Japanese yen, and the British pound have all registered multi-decade lows in 2022. Emerging-market currencies have taken a beating: The South African rand has lost 9.4%, the Hungarian forint has dropped 20% and the Egyptian pound has fallen 18%.
Foreign investors have been withdrawing funds from other markets and placing them with higher yields in the United States, contributing further to the dollar’s climb.
The dollar is also rising due to the global poor economic outlook amid the Ukraine war. As its multi-decade property boom ends, ‘world’s manufacturing hub’ China is underperforming now, with the COVID lockdowns taking a toll on its economy.
Recently, the Chinese Yuan and the dollar broke through a crucial threshold, with the dollar purchasing more than 7 Yuan for the first time since 2020. Japanese policymakers started publicly worrying that markets were escalating after remaining silent as the yen lost one-fifth of its value in 2022.
A stronger dollar benefits the US by lowering import costs, supporting attempts to control inflation, and giving Americans a record level of relative purchasing power. However, it is placing a strain on the rest of the world.
Raghuram Rajan, a finance professor at the Booth School of Business at the University of Chicago, said, “I think it’s still early days.” He lamented the effects of Fed policies and a strong dollar on the rest of the globe while serving as governor of the Reserve Bank of India previously. “We’re going to see high rates for a while. The weaknesses will increase.”
The World Bank predicted a global economic downturn and “a run of financial crises in emerging markets and developing nations that would cause them permanent harm.”
Rising dollar values have worsened smaller countries’ problems by raising the food and energy imports’ costs. These nations are witnessing a crunch in their foreign currency reserves. Even though commodity prices have been cooling off, developing countries are still under considerable pressure.
Frontier markets are already on the verge of collapse; a strong dollar is the last thing they need.
The central banks of emerging markets have taken strong measures.
To combat inflation and safeguard the peso, which has fallen over 30% against the dollar in 2022, Argentina boosted interest rates recently to 75%.
Ghana too increased its repo rates to 22%, but its currency is still losing value.
The Ukraine conflict has caused a record rise in inflation across Europe, which is exacerbated by increased energy prices.
Christine Lagarde, president of the European Central Bank, raised the alarm at the meeting on September 8, 2022 about the euro’s 12% decline, by saying it has “added to the accumulation of inflationary pressures.”
Although ECB slowed down its record pace of interest rate hikes, its Vice-President Luis De Guindos said that the Central Bank won’t revise its mid-term price stability goal of 2%, suggesting more rate hikes will follow in 2023 as well.
The uncompromising message increases worry that financial pressures are increasing for emerging nations outside of well-known weak links like Sri Lanka and Pakistan, which have previously requested assistance from the International Monetary Fund. The IMF’s latest country to initiate negotiations is Serbia.
The dollar’s strength increases the cost of repaying debts borrowed in the particular currency by governments and businesses in emerging markets. Data from the Institute of International Finance shows that emerging-market governments will have USD 83 billion in US dollar debt due by the 2023 end.
An economist at the UN Conference on Trade and Development named Daniel Munevar observed, “You have to look at this through a budgetary lens. As 2023 approaches, your currency suddenly depreciates by 30%. To make such [debt] payments, you’ll undoubtedly have to reduce your spending on healthcare and education.”
US Treasury Secretary Janet Yellen admitted that emerging economies, particularly those with sizable loans denominated in the dollar, could face difficulties due to the currency’s gain. However, she stated in July 2022 that she wasn’t concerned about a cycle that could halt global economic growth.
The dollar’s strength has impacted Wall Street, impacting the profits made by American businesses abroad and controlling investments in commodities like gold and oil.
Russ Koesterich, co-head of Global Asset Allocation at BlackRock, said, “The strong dollar has created a headwind for just about every major asset class.”
Investors and economists are boosting the possibility of international intervention to assist weaken the dollar, although they are cautious that the likelihood of such a measure is still low.
For example, to reduce the dollar’s value in response to worries that it was harming the world economy, the United States, France, West Germany, the United Kingdom, and Japan initiated the Plaza Accord in 1985.
Paresh Upadhyaya, director of the currency strategy at asset-management company Amundi US, said, “There could be some rationale for a coordinated intervention to weaken the dollar. A strong dollar is increasingly becoming a significant negative headwind for central banks outside the United States.”
The Chinese central bank has tried to support the Yuan by increasing the dollar liquidity available on the market. It has decreased the number of reserves banks must retain against their foreign exchange deposits and consistently sets the daily fixing, which serves as a benchmark for the currency, at a higher level than what the market anticipates.
Politicians in Japan worry that the yen’s decline to a 24-year low against the dollar harms the economy.
Because of increasing energy prices and the weaker yen, imports increased by 50% in August 2022, contributing to Japan’s highest monthly trade deficit (2.82 trillion yen, or approximately USD 20 billion).
Five ways the dollar could disrupt the global economy:
Increased inflation
Wood, metals, and petroleum are traded in US currency. The dollar’s strength makes these products more expensive in local currencies. In 2021, USD 100 in gasoline cost between £72 and £84 in British pounds. Gas per litre in US currency has also risen dramatically.
Inflation happens when energy and raw materials grow, raising consumer and company costs. When the dollar goes up, it makes it cheaper for the US to buy goods from other countries. This may help keep inflation down.
Threats to low-income countries
Most developing nations owe US dollars, so many owe more than they did a year ago. Many may need help finding the ever-increasing local money required to repay debts.
It’s happening in Sri Lanka and could spread. Either they raise taxes, print inflationary money, or borrow more. Depending on the path taken, the results could be a severe recession, hyperinflation, or a sovereign debt crisis. Developing nations with sovereign debt issues may take years or decades to recover, which is hard on their citizens.
Increased US trade deficit
The high dollar will cause less foreign demand for US goods. The difference between what the US exports and what it imports, called the trade deficit, is already almost USD 1 trillion annually.
Both Presidents Joe Biden and Donald Trump promised to reduce it, especially as it related to China. However, some economists are concerned that the US trade deficit increases borrowing costs and reflects the fact that many manufacturing jobs have relocated abroad.
Deglobalisation will worsen
Tariffs, quotas, or other import restrictions are the simplest way to stop a trade deficit from growing. Other countries respond to US protectionism by taxing and obstructing US goods. A stronger dollar boosts protectionism. It threatens world trade in an era of “deglobalisation” due to weakening western connections with China and Russia.
Eurozone worries
Weaker EU members like Portugal, Ireland, Greece, and Cyprus are now less vulnerable to investors driving up their borrowing costs to crisis levels. The EU’s European Stability Mechanism (ESM) and Eurozone investment banks retain a large amount of their national debt.
The rising dollar forces the ECB to raise interest rates to support the euro and regulate import prices, especially energy. It’ll squeeze debt-ridden Eurozone nations. Italy, the ninth-largest economy in the world, has government debts that exceed 150% of GDP.
The ultra-strong currency increases concerns about a global slump. Inflation and income erosion reduce consumer spending. Protectionism reduces commerce and investment. Finally, sovereign debt difficulties threaten many emerging nations and the Eurozone.