Global repercussions of the strong dollar

By on October 20, 2022 0

International Macroeconomics and Exchange Rates

International Macroeconomics and Exchange Rates


By Kathryn M. Dominguez·October 19, 2022

University of Michigan

The problem:

The dollar strengthened strongly against the currencies of many industrialized countries and emerging markets to reach a 20-year high. This appreciation of the dollar is seen as a major global challenge for most countries, especially emerging market economies. In the past, many countries would have adopted a strong dollar; indeed, emerging countries like China have often intervened in the foreign exchange markets in the hope of weakening the value of their currency to gain a trading advantage. But today, both advanced and emerging countries are struggling with further currency depreciation for a variety of reasons.

A strong dollar fuels inflationary pressures abroad and makes it more difficult to service dollar-denominated debt.

Facts:

  • The dollar has strengthened considerably. Since May 2021, the value of the euro against the dollar has weakened by 19%, the pound sterling by 20% and the Japanese yen by 25%. There was a similar, albeit lesser, strengthening of the dollar against emerging market currencies (see chart).
  • The strength of the dollar can be attributed to the relative attractiveness of US assets. The dollar strengthens when investment funds flow into the United States because buying American assets requires acquiring dollars. The Federal Reserve has raised interest rates more aggressively than other advanced economy central banks, including the European Central Bank, Bank of England and Bank of Japan, making dollar-denominated bonds relatively attractive relative bonds denominated in these other currencies. . The outlook for growth in the United States, although lowered by interest rate hikes to fight inflation by the Fed, is still better than that of many other countries – for example, supply disruptions in gas and oil due to the war in Ukraine affect European countries more severely than the United States. The dollar is also considered a “safe haven” currency and with the war in Ukraine there has been a flight to the dollar, driving up the US exchange rate.
  • The strength of the dollar is fueling inflationary pressures abroad. When a country’s currency weakens against the dollar, the price of imports from the United States increases, putting pressure on prices. On average, the impact of a 10% appreciation of the dollar on inflation abroad is 1%. This pressure extends beyond the direct import of goods from the United States: the prices of commodities like oil, wheat and metals are quoted in dollars, so a stronger dollar means a higher price. high for these things. Moreover, since food and energy expenditures account for a larger share of consumption in emerging economies, increases in the dollar prices of these commodities significantly increase their cost of living.
  • A weaker currency can help promote a country’s exports and the sales of its import-competing businesses, but there are also other effects that mitigate these trade benefits. The same firm that exports products may also depend on imported inputs for its production. The advantage of a cheaper price of a firm’s product, through currency depreciation, may be mitigated or even reversed by higher production costs due to the increase in the domestic currency price of inputs priced in dollars – both inputs imported from the United States and, more importantly, raw material inputs priced in dollars. For example, a weaker yen raises the cost of producing Sony’s PlayStation consoles and clothing sold by Asia’s biggest clothing brand, Uniqlo. The effect of a weaker currency is more complicated than the simple depreciation-export link.
  • A strong dollar makes it more difficult to service their debt for those who have borrowed in dollars but whose receipts are in another currency. This is a particular problem for governments and companies in emerging economies, as most of their borrowing is in dollars. In the years following the 2008 global financial crisis, emerging economies experienced strong capital inflows, global liquidity was high, and interest rates were low in advanced economies, making emerging economies attractive places to Investors. The external borrowing of emerging economies increased and more than 80% of this debt was denominated in foreign currencies, mainly in US dollars. The pandemic has led to a sharp reversal in capital flows, many emerging economies have suffered sovereign rating downgrades, and countries with high levels of external debt relative to foreign exchange reserves have suffered large-scale capital outflows and dramatic depreciations of their currencies.
  • A stronger dollar has been associated with a range of problems for emerging market economies, including declines in production, consumption, investment and government spending. A recent analysis by Maurice Obstfeld and Haonan Zhou finds that a dollar appreciation of 10% causes real GDP to decline by about 1.5% relative to trend in emerging market economies. They find that the negative effects of a strong dollar are greater for countries that fix their exchange rates, that have not adopted inflation-targeting monetary frameworks, and that have high levels of dollar debt. The negative impacts of a strong dollar for emerging economies are accentuated in the current context as many of these countries have increased their level of public and corporate debt due to the pandemic. A strong dollar increases the real value of dollar debts, higher interest rates increase the debt service burden, and slower growth reduces corporate profits and government tax revenues.
  • Central banks react to inflation, as well as currency weakness, by raising interest rates, but this has the effect of slowing down the economy and possibly causing a slowdown. The Federal Reserve took a more aggressive stance on inflation earlier than the European Central Bank, Bank of England or Bank of Japan. The relative strength of the US economy has allowed the Fed to continue raising interest rates to fight inflation, but there is a danger that these measures, coupled with similar policies taken by other central banks , together create an unnecessarily sharp global recession. Central bank mandates require policy actions to be based on national conditions, making it difficult to fully internalize the ripple effects of everyone’s actions, which could lead to an overly aggressive global monetary tightening cycle.
  • What can countries do to counter a stronger dollar? Several countries, including Japan, have recently intervened in the foreign exchange markets to strengthen their currencies by selling dollar assets. Foreign exchange reserves held by emerging economies fell by more than 6% in the first half of 2022 due to intervention efforts to defend their currencies against the rising dollar. These unilateral efforts temporarily slowed depreciations, but did not reverse the dollar’s ascent. Countries can also work in coordination to intervene to stabilize foreign exchange markets. There is a historical precedent for coordinated efforts to stop the rise of the dollar: in 1985, the United States, Japan, West Germany, France and the United Kingdom agreed to a joint intervention in the foreign exchange markets in what became known as the Plaza Accord. Countries proceeded to sell dollars in exchange for other currencies on the foreign exchange market and the value of the dollar fell (see here). But, unlike today, there was a broad consensus that the value of the dollar in 1985 exceeded that consistent with underlying fundamentals, so it is less clear that a “New Plaza Deal” would be as effective in today’s environment.

Large fluctuations in exchange rates can lead to coordination efforts, as well as currency wars, where countries go it alone against each other in an effort to manipulate the value of their currency at the expense of other countries. . Outside the United States, there is growing enthusiasm to launch another coordinated Plaza Accord-style intervention effort to drive down the value of the dollar. What makes the current environment different from the appreciation of the dollar in the 1980s is that there is little evidence of a dollar bubble today. The dollar is strong not because of overly exuberant market behavior, but because the US economy is expected to be stronger than most other economies for the foreseeable future, as well as higher dollar interest rates and the safe haven status of the dollar. The strength of the dollar could nonetheless become a concern for the United States if the global economy continues to falter and financial conditions deteriorate, leading to lower U.S. export sales and defaults by the debt of emerging economies. If the global repercussions of a strong dollar become too costly, it will be in the interest of the United States to join in the effort to bring it down.

Topics:

Exchange rate / International macroeconomics and exchange rate