The dollar has been depreciating this year. That's good news for American tourists wandering around Europe, but bad news for almost every other country in the world.
In 2022, the dollar appreciated more than 10 percent — near its highest level in 20 years — compared to other top currencies — as investors worried about a global recession snapped up the dollar, which was seen as a safe haven in times of turmoil. The Federal Reserve's aggressive interest rate hikes in response to decades of high inflation have added to the dollar's appeal. This makes investment in the U.S. more attractive because they now offer higher returns.
U.S. tourists may rejoice in a night in Rome, which once cost $100 and now cost $80, but the situation is more complicated for multinationals and foreign governments.
About half of international trade is denominated in dollars, which increases the bills of manufacturers and small businesses that rely on imported goods. Governments that need to pay off their debts in dollars can also be in trouble, especially with insufficient foreign exchange reserves.
The appreciation of the dollar has hurt some fragile economies.
Sri Lanka's dollar shortage led to the worst economic crisis in the country's history, eventually forcing its president to step down last month. At the end of July, the Pakistani rupee fell to record lows against the dollar, on the verge of default. Egypt, battered by rising food prices, is facing a depletion of dollar reserves and an outflow of foreign investment. All three countries had to turn to the IMF for help.
"It's a challenging environment," said William Jackson, chief emerging markets economist at Capital Economics. The dollar tends to appreciate when the U.S. economy is very strong, or when the U.S. economy is weak and the world is facing a recession. In either case, investors see the country's currency as an opportunity to lock in growth or a relatively safe place to store cash during a storm.
This phenomenon is often referred to as a "dollar smile" because it rises at both extremes.
But the rest of the world is not so ridiculous. Manik Narain, head of emerging market cross-asset strategy at UBS, points to three main reasons why a stronger dollar could hurt smaller countries in the global economy.
1. It may increase fiscal pressure. Not every country has the ability to borrow in its own currency because foreign investors may not have confidence in their institutions or their financial markets are not well developed. This means that some countries have no choice but to issue dollar bonds. But if the dollar appreciates, the cost of debt service will be higher, depleting government coffers.
This also makes it more expensive for governments or businesses to import food, medicine and fuel.
That's what happened earlier this year when the Sri Lankan rupee plummeted against the dollar. The government has depleted its foreign exchange reserves, which are already low, partly due to the decline in tourism during the pandemic. Shortages of basic items have taken thousands of people to the streets. After angry protesters occupied government buildings, President Gotabaya Rajapaksa fled the country and resigned in July.
2. It has fueled capital flight. When a country's currency depreciates sharply, wealthy individuals, companies, and foreign investors begin to divest, hoping to hide their money in safer places. This would further devalue the currency and exacerbate fiscal problems.
"If you're sitting in Sri Lanka right now and you see the government under pressure, you want to take the money out," Naran said. ”。
3. It affects economic growth. If companies can't afford the imports they need to run their business, they won't have as much inventory. This means that even if demand remains strong, they cannot sell so much, thus affecting economic output.
When the U.S. economy is growing at a high rate, this can alleviate some of the blows. Many emerging markets export goods to the world's largest economies. But when the dollar strengthens because the U.S. is on the brink of recession? It's hard.
"It could cause more pain to the market because in this context you don't have a silver lining for better economic growth," Naran said.
The crisis is under control
The dollar has fallen back 0.6 percent over the past week. However, it is not expected that this trend will be reversed meaningfully in the short term.
Scott Wren, senior global market strategist at the Wells Fargo Investment Institute, wrote in a recent note to clients: "We expect the dollar to remain largely strong in the short to medium term. ”。
That has prompted investors and policymakers to question whether Sri Lanka is just the first domino to fall. In addition, turmoil in emerging markets could spill over across the financial ecosystem, triggering widespread spillover effects.
Brad Setser of the Council on Foreign Relations recently wrote that he was monitoring Tunisia, which is struggling to meet its budgetary needs, and Ghana and Kenya, which have high debt burdens. El Salvador will pay its bonds early next year, while Argentina is still struggling after the last currency crisis in 2018.
The IMF estimates that 60 percent of low-income countries are at or are at high risk of government debt distress, up from about one in five a decade ago.
But there are also significant differences between the current situation and past crises.
Dollar-denominated debt is no longer as common as it used to be. According to Setser, the biggest players such as Brazil, Mexico and Indonesia "typically don't borrow a lot of foreign exchange and now have enough foreign exchange reserves to manage their external debt burden."
In addition, the prices of commodities such as oil and base metals remain high. This helps emerging economies in major exporters, including many Latin American countries, and is a sure way to ensure that the dollar remains flowing into government coffers.
Inflation has also prompted many emerging-market central banks to start raising interest rates earlier than the Fed or the Bank of England. Brazil launched the process in March 2021, raising borrowing costs at 12 consecutive meetings.
But the fate of the world's two largest economies — the United States and China — depends heavily on them. If these growth engines do start to stagnate, there could be painful investment outflows in emerging markets.
"Whether the U.S. is in recession or not is critical," said Robin Brooks, chief economist at the Institute for International Finance. "It makes everyone more risk-averse."
This article originated from the financial world