The Strong Dollar Is Scaring Foreign Economies. Here Are the 3 Reasons.
Small economies are scared to even more than large ones.
The year 2022 is shaping up to be a successful year for the US dollar. The euro to dollar rate has fallen this year from $1.14 to $1.02. This represents a drop of over 10%. This represents a drop of more than 10%. Earlier this year, we even reached parity (1 dollar = 1 euro).
So the question many people are asking is: why is the US dollar doing so well this year?
The greenback is considered a safe haven when a wave of uncertainty hits the financial markets. Despite a rally in the stock markets in recent weeks, the major indices are still in the red from earlier this year. This is partly due to the war in Ukraine.
The Fed's interest rate hikes are making U.S. government paper shine. For example, the U.S. ten-year interest rate has risen from 1.63% to 2.78% since the beginning of 2022. The growing interest in these assets is giving the dollar an extra boost.
The strong dollar and foreign economies
A strong dollar has both advantages and disadvantages for Americans themselves and foreign consumers. In any case, foreign economies are not very supportive of a (too) strong dollar. About half of all international trade is settled in dollars, which means that manufacturers and small businesses that rely on imported goods have to dig deeper into their pockets.
Governments that have to pay off dollar debts may also run into problems, especially if reserves are depleted. “It's a tough environment,” William Jackson, chief emerging markets economist at Capital Economics, commented to U.S. news site CNN. Manik Narain, a strategist at Swiss bank UBS, shares this belief. In particular, he warns of the dangers that foreign (and mainly small) economies may face. He mentions three of them.
The 3 reasons why foreign governments fear a strong dollar
1. Additional pressure on the budget
Not all countries can borrow money in local currency because foreign investors may not trust their institutions or because their financial markets are less developed. This means that some countries have no choice but to take on debt in dollars. These debts will become more expensive if the dollar performs well. In addition, companies and governments have to put more money on the table to import food, medicine, and fuel. The price of oil, for example, is expressed in dollars.
We are already seeing the consequences today. Sri Lanka's dollar shortage contributed to the worst economic crisis in the country's history, eventually forcing President Gotabaya Rajapaksa to resign in July 2022. Sri Lanka is certainly not the only country struggling, and Sri Lanka is also paying for its participation in China's BRI. That said, according to the International Monetary Fund (IMF), 53 countries, including Nigeria, Ethiopia, Ecuador, and Ghana, but also Egypt, Tunisia, and Pakistan are on the verge of collapse.
2. Capital flight
As I mentioned above, a strong dollar is driving more and more investors into the US market. This pushes the local currency even lower, exacerbating the fiscal problems.
3. A strong dollar stifles economic growth
More expensive products (in dollar terms) mean that companies may have difficulty replenishing their inventory. It also means they may sell less, which reduces sales. The decrease in economic activity leads to slower economic growth. This, combined with high inflation, can lead to stagflation.
Let's take Sri Lanka as an example again. Last month, inflation in Sri Lanka reached 60.8%. The central bank of this South Asian country does not rule out the possibility that the depreciation of the currency will reach 70% in the next two months. The regulator expects this to be the peak.
The only small trade-off is that if the U.S. economy is operating at full capacity, it could soften the blow somewhat for smaller economies. Many emerging markets export goods to the United States.
Some reading
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