The Strong Dollar Is a Danger to the World Economy, and It Has Already Taken Its First Victims.

The dollar's rise is probably not over.

Since the beginning of the year 2022, the US dollar has appreciated by 10% against the euro. The dollar index, which tracks the greenback's evolution against the United States' main trading partners, has experienced a similar amplitude of progression (+11% since January 1). This is good news for American tourists, whose purchasing power has increased by about 10% just because of the exchange rate effect.

It is bad news for the rest of the world.

A strong dollar hurts the entire global economy. More than half of all international trade is settled in dollars. It is easy to imagine the negative effect this can have on businesses of all sizes and individuals. Governments are not spared. Many emerging countries have part of their debt denominated in US dollars. Some can cover maturing interest payments by drawing on their foreign exchange reserves. But not all can.

The bad news is that the dollar's rise is certainly not over. If the global economy goes into recession, capital flows will recycle into the U.S. market as a safe haven. This is what is happening systematically. In turn, this will drive the dollar exchange rate even higher.

The U.S. dollar takes its first victims

There are always warning signs before a global crisis. This is certainly the case with Sri Lanka's default in April 2022 (the first this year). The country was faced with a difficult choice. It could either use its dollars to pay foreign creditors or it could use them to pay for food and energy imports. The latter choice prevailed.

Other economies are struggling. Egypt is struggling with a food crisis, a drastic decline in dollar reserves, and a flight of foreign capital. By the end of 2023, the country will need at least $41 billion to cover both the current account deficit and maturing dollar debt. Foreign exchange reserves can be used (they stand at $33 billion). But this will not be enough. Moreover, there is no other readily available source of financing (the Gulf countries are reluctant to commit and international organizations want structural reforms first).

The only option is a devaluation of the currency, the Egyptian pound. This would reduce the trade deficit (by making exports more competitive and imports more expensive). The downside is that it would continue to increase inflationary pressures. Inflation is at 13.4% year-on-year (the latest figure for May). This is the only credible option at this point, however.

The economic environment is becoming increasingly complicated for a myriad of emerging and developing countries. This is also the case for Pakistan, Tunisia (which has serious fiscal difficulties), Ghana, and Kenya (both countries have worrying levels of debt) but also for El Salvador and for Argentina (Argentina is still feeling the full brunt of the latest currency crisis in 2018).

The big emerging countries are immune, on the other hand. Brazil, Mexico, and Indonesia have, as a rule, borrowed little in foreign currency in recent years. In any case, they have sufficient foreign exchange reserves to meet their commitments to foreign creditors. A crisis in the emerging countries is therefore unlikely.

The scenario that is emerging is that of a gradual destabilization of the weakest links (as was the case with Sri Lanka) without this leading to contagion to all emerging countries and/or a systemic crisis.

This is the major difference compared to previous crises (the 1980s, 1990s, in the wake of the global financial crisis of 2007-08, etc…).

The bad Chinese surprise

The rise of the US dollar is also having unexpected effects. It is weakening the Chinese economy. According to our estimates, the capital flight that is taking place at the moment is reaching the proportion known in 2015-16 at the time of the devaluation of the yuan. This is not related to the geopolitical context (tensions between Beijing and Taiwan). It is largely linked to the rise of the greenback. This same factor led to several forced devaluations of the Chinese currency in 2015.

It certainly won't happen this time. The Chinese economy is more compartmentalized. Beijing has learned the lessons of a surprise devaluation (crisis of confidence of foreign investors). Moreover, it is hard to see how a devaluation could happen only a few months before the 20th Congress of the Chinese Communist Party, which will reappoint President Xi Jinping for another five-year term. It would be a slap in the face.

Capital flight also reflects a lack of confidence in the Chinese economy. Entire sectors are moribund. This is the case in the real estate sector, which has been the main engine of growth over the past decade. According to data published by the Chinese media group Caixin, 62.5% of real estate developers were unable to pay their suppliers in June 2022. This concerns more than 1600 real estate projects. Last January, the percentage was only 24% (a few months after the collapse of Evergrande) for a total of 135 projects. The increase is impressive in such a short period.

A sudden collapse of Chinese real estate is unlikely. However, the long deflation of bubbles and the cleaning up of developers' accounts will take time, probably several years. This will weigh on the growth dynamic and accentuate capital flight. It will also delay the internationalization of the Chinese yuan, which requires a greater degree of exchange rate flexibility. This is impossible under these circumstances.

The economic and financial environment is unique in many ways. Unlike the last global economic and financial crisis of 2007-08, there is no growth relay (many emerging countries are weakened and China is facing a palpable slowdown). Stagflation is taking hold in many countries (Germany, for example). Others are sinking into recession (UK).

The US dollar is back in the game (as is always the case in times of crisis, even when the crisis first occurs in the US). This should soon be the turn of the Japanese yen (despite some recent setbacks). The major currencies remain relatively stable (the pound sterling managed to survive the Brexit, it will survive a long recession that could last five quarters according to the Bank of England).

The euro's bearish bias against the U.S. dollar remains (with certainly a possible pullback to 0.90 by the end of the year 2022). It is more a question of a long agony than a brutal fall. The currency disorder is more likely to be in the minor currencies (Pakistani rupee, Ghanaian cedi, etc...). This is likely to put a strain on the ability of the central banks concerned to intervene in the foreign exchange market and stabilize their currencies.