The Dollar has just gone up by around 19%, according to the Dollar Index (DXY), which is measures the strength of the USD relative to a basket of other foreign currencies. This simply means that it is now more expensive to buy dollars, and dollars can buy more of other currencies. To put things into context, the dollar is now at parity with the euro ($1 could be exchanged for €1), for the first time in 20 years.
Figure 1: DXY graph for 2022
So why has the dollar been strengthening so dramatically?
Inflation in the US has spiraled out of control this year reaching up to 9.1% in June 2022, almost 5 times the Federal Reserve’s target rate of 2%. The pandemic has caused mass food supply chain disruptions causing food prices to rise. The Russian invasion of Ukraine has led to a global spike in energy prices. Fertiliser shortages from Ukraine, topped with poor harvests and livestock illnesses, have jacked food prices up even higher. The daunting effects of international crises have spilled over to domestic households in the USA and consumers are paying the price.
In order to combat the rising inflation, the Fed has taken a hawkish monetary policy stance to keep inflation under control. By raising interest rates, borrowing costs would increase and in theory, this would reduce demand, easing the upward pressure on prices. Hence in just 6 months, the Fed has raised interest rates from 0.25% to a staggering 3.25%, with aggressive rate hikes of 75 basis points (0.75%) in June, July, and September. And the Fed doesn’t aim to stop there just yet – it is expected that the Fed will raise their interest rates to 5% by March 2023 in order to curb the two-decade-high inflation.
Figure 2: Federal reserve interest rates in 2022
When the Fed raises its interest rates, the demand for the greenback increases as investors worldwide seek to profit from higher short-term interest rates. These inflows of foreign funds into the US are known as “hot money”. To better illustrate this mechanism, foreign investors could get higher returns when they deposit money in a US bank, rather than in a European bank, when interest rates in the US are higher. As such, investors are more inclined to exchange their money for dollars to be deposited. Following the mechanism of demand and supply, the value of the currency would then gain strength.
Interest rates aren’t the only factor driving up the demand for the USD – stocks, bonds, real estate, and cryptocurrency are underperforming and have just become riskier to invest in. The USD benefited from a confluence of recent events – volatile financial markets, supply chain issues, global inflation, etc. With less confidence to invest in riskier assets, investors opt to place their money on the dollar which is regarded as their safe haven, an asset that could retain or even increase its value during an economic downturn.
How is this important to other countries?
Being the world’s reserve currency, the dollar plays a significant role in the international market. Most international financial transactions take place using the USD – a large portion of international loans and about 60% of international and foreign currency liabilities are denominated in U.S. dollars, USD. With the dollar’s global significance, the impact of its strengthening reaches beyond its borders and affects financial markets around the world.
Among them, emerging markets (EM) have been hit particularly hard by the stronger dollar. Emerging markets are generally developing economies that are transitioning to being “developed” through industrialisation, such as Brazil, Malaysia, China, and Pakistan. Despite experiencing rapid economic growth, most open emerging economies are price takers when it comes to international trade – their economies are not significant enough to affect the global market.
Imported inflation and trade troubles
In emerging economies, dollar strength translates into higher import costs. Due to the dollar’s stability and store of value, most key commodities such as crude oil, wheat, and copper are priced in dollars when traded. With the USD on the rise, the purchasing power of non-US currencies declined and imports became more expensive for EMs. Hence, there arises a concept that a higher-valued dollar exports inflation to other economies. Annual inflation in Argentina skyrocketed to a rate of 50%, and Turkey at 70%. Countries such as Turkey, Egypt, and Kenya are deemed to be at financial risk due to their heavy reliance on food and energy imports while experiencing major current account deficits.
A significant rise in the dollar would in turn depress global trade growth as countries become less engaged in trade, in light of spiking commodity prices. For most developing countries that are especially dependent on global trade, the value of their GDP would likely take a hit. This is unfavourable for China – small and medium enterprises may experience a squeeze in profitability as the renminbi weakens against the dollar. It would likely produce knock-on effects and exacerbate the situation in EMs given their ties with Chinese supply chains and export markets.
However, this may not be the case for export-led EMs. On the flip side of imports being more expensive, EMs exports become cheaper for foreign buyers. Increased foreign demand for exports means GDP would increase, which helps to offset other negative impacts of the stronger dollar. Commodity-exporting economies could also benefit from dollar-strengthening. As the world’s largest copper exporter, Chile saw its currency gain 8% in the first quarter since the dollar’s value was raised. However, the Chilean Peso dropped afterward due to slowing world copper demand stemming from production cuts in China.
Capital flight and dampened economic growth
Most emerging economies rely heavily on foreign investments as it forms the basis for businesses and the economy to grow. However, as the US hikes its interest rates, foreign funds totaling more than $38bn have pulled out from EMs within five consecutive months in 2022, indicating the longest period of net outflows since 2005. The US has become a more attractive destination to secure funds as federal rates have risen. Fears of a recession have also led investors to retrench their funds from riskier EMs and flee to safer assets.
To remain competitive, EMs have to follow in the footsteps of the US and raise their interest rates. In other words, higher returns have to be promised to avoid capital flight from an EM to less-risky US assets. This leads to a dilemma for emerging economies – rate hikes are ideal to protect foreign investments, but on the other hand, they would increase borrowing costs. This would dampen aggregate demand and lead to downward economic growth, pushing some EMs to be at risk of a recession.
Debt becomes more expensive
EMs rely on debt to finance expenditures in both private and public sectors, and they repay the money slowly over time with interest rates. They may take out debts in the form of government-issued securities or direct loans from financial institutions.
A feature of debt is that they are often dollar-denominated, due to the fact that lenders deem the dollar far less volatile than currencies of emerging markets. Since the dollar has strengthened against other currencies, it became more expensive for EMs to service their debts. This is because emerging countries have to convert their domestic currency into USD to pay off most of their debts, meaning additional financial stress is placed on emerging markets. When USD: MYR = 4.0, an initial debt of $1000 could be paid back with RM4000, but when the exchange rate rises to 4.7, a larger figure of RM4700 is needed.
As the Covid-19 pandemic had pushed borrowing in emerging economies to an all-time high, the financial stress arising from a more expensive debt has been magnified. During the pandemic, huge expenditures on fiscal stimulus, coupled with lowered tax revenue due to unemployment, have resulted in extensive government borrowing. In 2020 alone, debt amounted to 207% of the GDP in emerging economies. With a quarter of the debt being dollar-denominated, the rise in USD has accounted for a major increase in debt repayment figures by emerging economies.
Sri Lanka just defaulted on its foreign debts in April, and countries such as El Salvador, Ghana, Pakistan, Tunisia, and Egypt are at risk of defaulting too, according to statistics from Bloomberg. When the risk of default is high, bond yields also rise, meaning that dollar-denominated debt has just become an even bigger burden for emerging markets. Governments borrow money from investors to finance their expenditures, by selling bonds and offering each bond with returns (known as yields). Bond yields typically increase to compensate for the increased risk of defaulting (not paying) on the bond. Therefore, because of the financial stress that EMs are experiencing, the default risks of EM bonds have increased. Hence, higher bond yields have to be offered to entice investors.
Conclusion
The strengthening of the dollar has just made the situation for EMs recovering from the pandemic much more complicated – imported inflation leading to trade decline, international capital flow reversals, and heavier debt burdens.
Some argue that despite the Fed’s mandate to solve domestic issues, it should take its decision’s impact on the rest of the world into account. This is because economies have become much more interdependent on each other than before, as a result of financial and trade globalisation, said Mr. Obstfeld, a U.C. Berkeley economist. However, most economists hold the stance that despite the fallouts of a stronger dollar, the effects on other countries would be even worse if inflation in the US is not lowered to a targeted level.
So if pushing the dollar up is necessary, how could EMs minimise the negative impacts imposed on them? The increasing reliance on floating currencies may offer an answer. As opposed to pegging currencies in the past, EMs have now gained greater leverage over managing the value of their currency by utilising deeper foreign-exchange reserves. Some EMs such as Brazil are already responding to the Federal Reserve’s rate hikes with rate hikes of their own which has effectively countered inflation and currency declines against the USD. So far, some EMs are demonstrating astounding resistance to the vicious global financial conditions. The IMF has forecasted that EMs are expected to outgrow major economies this year and next.
Not all EMs however enjoy the stability that some of their counterparts experience. A strong headwind is approaching not only these EMs, but the world as a whole.
(1740 words)
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Researcher(s): Alexander Chen, Eunice Jong
Reviewer(s): Nasir Ali
Editor(s): Maryam Nazir Chaudhary
Designer(s): Erdina Mysarah
