The US dollar is enjoying a once-in-a-generation rally, a surge that threatens to exacerbate a slowdown in growth and compound inflation problems for central banks around the world.
The dollar’s role as the primary currency used in global trade and finance means that its fluctuations have far-reaching implications. The strength of the currency is reflected in Sri Lanka’s fuel and food shortages, Europe’s record inflation and Japan’s skyrocketing trade deficit.
This week, investors are closely watching the outcome of the Federal Reserve meeting for clues as to where the dollar is heading. The US Federal Reserve is expected to hike interest rates by at least 0.75 percentage point on Wednesday as it fights inflation – likely leading to further dollar gains.
It is a worrying sign that attempts by policymakers in China, Japan and Europe to defend their currencies are largely failing in the face of the dollar’s inexorable rise.
Last week, the dollar overran a key level against the Chinese yuan, with the dollar buying more than 7 yuan for the first time since 2020. Japanese officials, who previously stood by as the yen lost a fifth of its value this year, began to publicly resent markets going too far.
The ICE US Dollar Index, which measures the currency against a basket of its largest trading partners, is up more than 14% in 2022, on course for its best year since the index’s inception in 1985. The Euro , the Japanese yen and the British pound have all managed to fall to decade-lows against the greenback. Emerging market currencies took a hit with the Egyptian pound falling 18%, the Hungarian forint down 20% and the South African rand down 9.4%.
The dollar’s rise this year is being fueled by the Fed’s aggressive rate hikes, which have encouraged global investors to pull money from other markets to invest in higher-yielding US assets. Recent economic data suggests that US inflation remains stubbornly high, strengthening the case for more Fed rate hikes and an even stronger dollar.
The bleak economic outlook for the rest of the world is also giving the greenback a boost. Europe is on the front lines of an economic war with Russia. China faces its biggest slowdown in years as a decade-long housing boom unfolds.
For the US, a stronger dollar means cheaper imports, tailwinds for efforts to contain inflation, and record spending power for Americans. But the rest of the world is suffering from the rise in the dollar.
“I think we’re just getting started,” said Raghuram Rajan, a finance professor at the University of Chicago’s Booth School of Business. When he was Governor of the Reserve Bank of India last decade, he was vocal about how Fed policy and a strong dollar were hitting the rest of the world. “We will be in a high interest rate regime for some time. The fragility will build up.”
Year-to-date performance against the US dollar
On Thursday, the World Bank warned that the global economy was headed for recession and “a series of financial crises in emerging and developing countries that would do lasting damage”.
The strong message adds to concerns that financial pressures are mounting on emerging markets outside of known vulnerabilities such as Sri Lanka and Pakistan, which have already sought help from the International Monetary Fund. Serbia was the latest to open talks with the IMF last week.
“Many countries have not seen a cycle of much higher interest rates since the 1990s. There’s a lot of debt out there, compounded by borrowing during the pandemic,” Mr Rajan said. Stress in emerging markets will spread, he added. “It will not be contained.”
A stronger dollar makes it more expensive to repay the debt that emerging market governments and companies have taken on in US dollars. Emerging market governments have $83 billion in US dollar debt due by the end of next year, according to data from the Institute of International Finance, which covers 32 countries.
“You have to look at this from a budgetary perspective,” said Daniel Munevar, an economist at the United Nations Conference on Trade and Development. “You enter 2022 and suddenly your currency falls 30%. They will likely be forced to cut health care and education spending to meet them [debt] payments.”
Cumulated interest rate changes since January 2021
The Central Bank of Brazil begins raising its rate
Interest rate in March 2021
The currency’s rise has compounded the pain in smaller nations by making essential food and fuel imports, denominated in US dollars, more expensive. Many have drawn on holdings of dollars and other foreign currencies to finance imports and stabilize their currencies. And although commodity prices have fallen from their peaks in recent months, it has done little to ease the pressure on developing countries.
“Further appreciation in the dollar will be the last straw,” said Gabriel Sterne, head of emerging markets research at Oxford Economics. “They are already putting frontier markets at the tipping point towards crisis, the last thing they need is a strong dollar.”
Emerging market central banks have taken drastic steps to stem the depreciation of their currencies and bonds. Argentina hiked interest rates to 75% on Thursday to stem rising inflation and defend the peso, which has lost nearly 30% against the dollar this year. Ghana also surprised investors last month by raising interest rates to 22% – but its currency continues to fall.
Not only the emerging countries are struggling with weaker currencies. In Europe, the weakness of the euro is amplifying a historic spike in inflation caused by the war in Ukraine and a consequent rise in gas and electricity prices.
At the European Central Bank’s meeting on September 8, President Christine Lagarde expressed concern over the euro’s 12% fall this year, saying it had “increased inflationary pressures”. The ECB is signaling a more aggressive monetary policy stance, with investors now expecting interest rates to rise to 2.5%. But that has done little to improve the currency’s value.
The ECB is powerless against the dollar’s strength, said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “Whether the ECB turns more hawkish, whether the economic outlook improves somewhat, whatever happens, it will generally be offset by further dollar strength,” he said.
US Treasury Secretary Janet Yellen acknowledged that the dollar’s appreciation could pose challenges for emerging markets, particularly those with high dollar-denominated debt. But she said in July she wasn’t concerned about a self-reinforcing cycle that could slow global economic growth.
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The dollar’s strength has spread to Wall Street, weighing on US corporate profits overseas and keeping investment tied to commodities like gold and oil in check.
“The strong dollar has created headwinds for nearly every major asset class,” said Russ Koesterich, co-head of global asset allocation at BlackRock.
“It’s another aspect of the tighter financial conditions and that’s affecting everything.”
Investors and economists are raising the prospect of global action to weaken the dollar – although they warn the likelihood of such a move remains slim. In 1985, the US, France, West Germany, Britain and Japan launched a joint effort known as the Plaza Accord to devalue the dollar amid concerns it was weighing on the world economy.
“There may be some justification for coordinated intervention to weaken the dollar,” said Paresh Upadhyaya, director of currency strategy at asset management firm Amundi US. “Outside the US, a strong dollar is now becoming a massive negative headwind for central banks.”
China’s central bank has attempted to prop up the yuan by allowing more dollar liquidity into the market. It has reduced the level of reserves banks are required to hold against their foreign exchange deposits and consistently set the daily fixing – a reference point for the currency – higher than market expectations.
Chinese regulators’ heightened sensitivity to the yuan’s decline may stem from their concern that a weak yuan could further dampen consumer confidence, said Tommy Xie, head of research and strategy for Greater China at OCBC Bank.
“A depreciating yuan can trigger a vicious cycle,” said Mr. Xie.
In Japan, policymakers fear that the yen’s fall to a 24-year low against the dollar will hurt businesses. Bank of Japan Governor Haruhiko Kuroda said this month that the yen’s sharp depreciation “is likely to make corporate business strategy unstable.”
The yen’s weakness helped Japan post its largest monthly trade deficit in August – 2.82 trillion yen, the equivalent of about $20 billion – as the value of imports plummeted due to higher energy prices and the currency’s depreciation increased by 50%.
Prime Minister Fumio Kishida said on Wednesday that Japan must find ways to capitalize on the positive effects of the yen’s depreciation. One solution: invite more tourists.
“It is important to step up efforts to increase our nation’s profitability,” he said.
—Julia-Ambra Verlaine contributed to this article.
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