Causes and consequences of the strong dollar

The US dollar is on course to exceed levels reached in 20 years, gaining nearly 18% in the last 12 months. The sharp and fast rise in the value of the world's most widely used currency since World War II affects global trade and finance in different ways. John B Connally, a former US Treasury Secretary, famously told the Europeans in the early 1970s that the dollar "is our currency, but it's your problem."

The soaring dollar

Indeed, the value of the USD matters for all. The USD appears in about 90% of the currently $6.6 trillion-a-day foreign exchange transactions, half of all international debts and 59% of globally disclosed holdings of foreign exchange reserves (IMF data).

The role of the USD does not depend on a "strong dollar policy". The Fed targets domestic inflation using domestic instruments that do not target exchange rates. The USD floats freely and the Fed does not directly intervene in the foreign exchange markets.

The dollar's strength is gauged by the Dollar Index (DI) against a basket of currencies. Increase in the index indicates the composite of USD gains with respect to euro, yen, pound sterling, Canadian dollar, Swedish krona, and Swiss franc. At over 109 on August 31, 2022, the USD has been stronger on only three occasions (1969, 1985, 2002) since the 1960s.

Most other currencies have lost value against the dollar, especially in 2022. The yen sank to a 24-year low, the euro fell to a one for one with the dollar for the first time since 2002, and the British Pound depreciated about 12%. These three account for over 80% of the DI basket. The yuan, the principal unit of account for the Chinese Renminbi, depreciated 8.8%. Argentina, Chile, and Colombia have suffered the worst devaluations of their currencies against the dollar. All currencies in South and Southeast Asia depreciated in varying degrees. There are only a few exceptions (Angola, Russia, Uruguay, Brazil).

The story

Simultaneous interplay of elevated commodity prices, delayed but aggressive monetary policy tightening in the US, and lingering geopolitical conflicts drove the rise of the dollar. Investors tend to hedge their bets with dollar-based investments in inflationary and recession-adjacent periods.

The biggest price pressures have evolved from energy and food to many more prices, including all sorts of goods and services. The US is possibly entering a third inflationary wave where wages may be a main driver. The world of deficient aggregate demand two years ago has morphed into deficient aggregate supply. The Fed, like most central banks around the world, thought inflation was temporary, caused by pandemic pressures, until realising it needed taming, albeit at a cost.

The Fed has increased interest rates faster than other major central banks after keeping them at near zero for much of the pandemic.

This is the most aggressive rate hike cycle since the Volcker era in the early eighties. Analysts at the Bank of America estimated that at least half the rise in the dollar this year could be explained by the Fed's comparatively aggressive policy alone.

Most of the other half is attributable to increased global uncertainty. The level of uncertainty is more synchronised across advanced economies with their tighter trade and financial linkages. The World Uncertainty Index, a quarterly measure across 143 countries, is considered a leading indicator of output declines. It was nearly 2.5 times in the first quarter of 2022 relative to its level in the first quarter of 2021. The 48% rise in WUI in the first quarter of 2022 alone could reduce full-year global growth by up to 0.35 percentage points (IMF blog). With the worsening of the growth outlook for the world economy, global investors have flocked to US Treasury bonds.

Dollar retreat unlikely

The dollar could drop if the war in Ukraine ceases, the US enters a recession, the Fed cuts interest rates, and the US government pursues fiscal consolidation; all fairly unlikely. Global reserve managers have in recent years diversified their portfolios towards non-traditional reserve currencies, including the Chinese renminbi, out of concerns about unilateral sanctions. Some countries are renegotiating the currency in which they get paid for trade. However, such efforts have slim chances of going far enough. There is no viable alternative to the dollar. In fact, the dollar has never been more entrenched. Europe does not have an equivalent safe asset and China is maintaining capital controls.

The USD might rise a bit more. In his speech on August 26, 2022, the Fed Chair indicated a more constrictive monetary policy "for some time". The Fed has also begun quantitative tightening to further address inflation risks. These notwithstanding, the largest part of the dollar rise may well be in the rear-view mirror. The European Central Bank is now poised for a major rate hike in September.

The gains are likely to persist until the uncertainties dissipate and the interest rates stabilise. The US is relatively insulated from the energy related uncertainties. As Europe braces for an energy crisis, persistent inflation forces US interest rates upwards, Japan resists raising interest rates, China locks its supply chains, and other countries sweat the heat of inflation and sovereign debt defaults, demand for the USD looks robust. Together with geopolitical tensions, these will probably keep the USD elevated.

The spillovers

The rise of the USD has consequences beyond its origin. A large share of credit, trade and debt involving hundreds of developing economies is priced in dollars. Swings in exchange rates vis-à-vis the USD are typically linked to capital outflows, tighter financing conditions and heightened financial instability. The Financial Times recently reported that "foreign investors have pulled funds out of emerging markets for five straight months in the longest streak of withdrawals on record". Developing countries suffered over $61 billion in outflows by mid-May this year.

Economist Zahid Hussain. Illustration: TBS

Changes in the USD affects world inflation. A rise in import prices after appreciation of the dollar increases inflation both directly and indirectly, through an increase in the costs to all domestic firms using imported goods as inputs. Commodities such as oil, food and nickel are priced in dollars. Other countries have to pay more in their currency to buy these. The high USD perpetuates the pain of inflation in smaller economies.

Many companies and governments borrow in dollars. The USD's strength stresses the poorer countries whose dollar debt represents a large portion of their GDP. Debt-service burdens in middle-income countries are at 30-year highs, according to the IMF. Sri Lanka has already defaulted on its debt. The likelihood of default across a string of countries like El Salvador, Ghana, Tunisia, Pakistan, Egypt, Kenya, and Argentina is growing. On the other hand, the USD serves as a hedge against their own currencies for nations holding their reserves in the USD. Bangladesh, for instance, has 75% of official reserves in the USD, although they are depleting too fast for comfort.

Long term impact on prices

There is normally an inverse relationship over time between the value of the USD and commodity prices. The correlation isn't perfect. Commodity prices don't generally go lower for every higher tick in the DI. It is mostly the energy and industry-related commodities, used globally and quoted in USD, that show the strongest correlation over time.

Commodity production depends on conditions in their specific locations, but the companies who want these important raw materials are located all over the globe. When the USD strengthens, commodities priced in USD, particularly in international trade for raw materials, become more expensive in non-dollar currencies.

Commodities are global assets. They trade all over the world. Foreign buyers store cash in US commodities such as corn, soybeans, wheat, and oil with USD. When the USD rises, they have less buying power. It requires higher amounts of their currencies to store in US commodities.

The combined effect of the above is to soften the demand for commodities. Selling at any price in order to secure USD dampens commodity prices even further. The degree of dependence varies among individual commodities. There are other factors mediating the effect of currency movements – change in weather patterns, infrastructure, and supply-chains, and the ease of substitution of one type of commodity for another.

The futures markets are currently betting that crude oil and natural gas prices will decline in 2023 relative to their monthly levels in 2022. This could, at least in part, be the consequence of a persistently strong USD.

Bane or boon?

The long-term trade prospects are uneven. Historically, periods of USD appreciation have coincided with softer real GDP growth rates in emerging market regions, especially large net commodity exporters. A strong dollar has an income effect owing to the inverse impact on global commodity prices, other things equal. Weaker commodity prices depress domestic demand in emerging markets via lower real income in dollars. Real GDP decelerates. These effects hold despite any potential expenditure-switching towards domestic goods resulting from their currency depreciation.

External demand for manufactures exported by the developing economies benefit from the rise of the dollar, albeit not immediately because of sticky dollar invoicing. A higher dollar transfers demand from the US to economies around the world when the USD real effective exchange rate appreciates with the appreciation of the nominal effective rate as may have been the case in the current cycle.

More immediately, a strong USD boosts US tourists abroad and remittances from the US to developing economies. These could be offset by increased cost of importing capital and intermediate inputs, the evaporation of foreign capital, tighter financial conditions, and rising debt burdens.

So, what to expect? Most forward-looking indicators suggest a palpable slowdown in global growth this year and next. Diversified export-led economies with a low share of dollar-denominated debt and large dollar reserves will stay ahead of others where investments, trade and debt are troubled. Developing nations such as Bangladesh will confront tighter financial conditions, challenging macroeconomic management and foreign exchange acquisition to keep their production systems running.