America’s strong dollar hurts everyone else

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The greenback is up more than 10% against other top currencies in 2022 — near its highest level in two decades — as investors worried about a global recession rushed to find dollars buried in turbulent times as a safe haven. Adding to the attractiveness of the dollar is that of the Federal Reserve aggressive campaign rate hikes to fight decades of inflation. This has made American investments more attractive as they now offer higher returns.

US travelers might be happy that a night in Rome that used to cost $100 now costs about $80, but for multinationals and foreign governments it’s a more complicated picture.

About half of international trade is billed in dollars, which pile up bills for manufacturers and small businesses that rely on imported goods. Governments that have to repay their debt in dollars could also run into trouble, especially if reserves are running low.

The dollar’s appreciation is already hurting some vulnerable economies.

A shortage of dollars in Sri Lanka contributed to this worst economic crisis in the country’s historyeventually force its president outside of the house Last month. The Pakistani rupee fell to a record low against the dollar in late July, pushing it to the edge of default. and Egypt — battered by soaring food prices — is dealing with a depleted dollar supply and an exodus of foreign investment. All three countries had to turn to the International Monetary Fund for help.

“It’s been a challenging environment,” said William Jackson, chief emerging markets economist at Capital Economics.

Why the “dollar smile” leads to frowns

The US dollar tends to appreciate when the American economy is very strong or, counterintuitively, when it is weak and the world is headed for recession.

In both situations, investors view the country’s currency as an opportunity to ensure growth or as a relatively safe place to park cash while it weathers the storm.

The phenomenon is often referred to as the “dollar smile” because it increases at both extremes.

But the rest of the world has less reason to smile. Manik Narain, Head of Cross-Asset Strategy for Emerging Markets at UBS, identified three main reasons a stronger dollar could hurt countries around the world with smaller economies.

1. It can lead to tax burdens. Not every country has the ability to borrow money in its local currency as foreign investors may not trust their institutions or they may have less developed financial markets. That means some have no choice but to issue dollar-denominated debt. But when the value of the dollar shoots up, it makes it more expensive to repay their debt and drains the treasury.

It also makes it more expensive for governments or companies to import food, medicine and fuel.

That’s what happened when the value of the Sri Lankan rupee plummeted against the dollar earlier this year. The government has drained its foreign exchange reserves, which were already low in part due to a slump in tourism during the pandemic. lack of important articles then brought thousands of people onto the streets. President Gotabaya Rajapaksa fled the country and resigned in July after angry protesters occupied government buildings.

2. It fuels capital flight. When a country’s currency weakens dramatically, wealthy individuals, businesses, and foreign investors begin to withdraw their money, hoping to stash it somewhere safer. That pushes the currency even lower, exacerbating fiscal problems.

“If you’re sitting in Sri Lanka right now and you see the government is under pressure, you want to get your money out,” Narain said.

3. It weighs on growth. If companies can’t afford the imports they need to run their businesses, they won’t have as much inventory. That means they can’t sell as much even if demand remains robust and weighs on economic output.

If the US economy is chugging along, that can cushion the blow somewhat. Many emerging countries export goods to the world’s largest economy. But if the dollar strengthens because America is on the brink of recession? That is hard.

“That can inflict even more pain on the markets because you don’t have the silver lining of better economic growth in the background,” Narain said.

Contain a crisis

The dollar is down 0.6% over the past week. However, there is not expected to be a significant price correction anytime soon.

“We expect dollar strength to remain broadly intact over the short to medium term,” Scott Wren, senior global market strategist at the Wells Fargo Investment Institute, wrote in a recent note to clients.

That forces investors and policymakers to wonder if Sri Lanka is just the first domino to fall. There is also a risk that the turmoil in emerging markets could spill over into the financial ecosystem and trigger a variety of spillovers.

Brad Setser of the Council on Foreign Relations wrote recently that he oversees Tunisia, which is struggling to meet its budgetary needs, and Ghana and Kenya, which have heavy debt burdens. El Salvador has a bond payment to make early next year, while Argentina continues to struggle after its last currency crisis in 2018.
The IMF estimated that 60% of low-income countries are in or at high risk of a sovereign debt crisis compared to about a fifth ten years ago.
Volunteers serve free meals to those in need at a community kitchen in Colombo, Sri Lanka on August 4.

But there are also significant differences between the current situation and past crises.

Dollar-denominated debt is less common than it used to be. The biggest players — like Brazil, Mexico and Indonesia — “have generally not borrowed much foreign currency and now hold enough foreign exchange reserves to support their external debt burdens,” Setser said.

In addition, prices for commodities such as oil and base metals remain high. That helps emerging economies that are big exporters, including many in Latin America, and serves as a reliable way to ensure dollars keep flowing into the coffers.

Inflation also prompted central banks in many emerging markets to raise interest rates earlier than their peers at the Federal Reserve or the Bank of England. Brazil has raised borrowing costs 12 consecutive meetingsafter the process was initiated in March 2021.

Still, much could depend on the fate of the world’s two largest economies: the United States and China. If these engines of growth really falter, emerging markets could experience a painful outflow of investment.

“It will be crucial whether the United States goes into recession,” said Robin Brooks, chief economist at the Institute of International Finance. “It makes everyone more risk-averse.”

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