America’s strong dollar hurts everyone else

CNN Business

The US dollar has weakened this year. This is good news for American tourists touring Europe, but bad news for almost every other country in the world.

The greenback rose more than 10% in 2022 against other major currencies – near its highest level in two decades – as investors worried about a global recession rushed to scoop up dollars seen as safe havens a refuge in turbulent times. Adding to the dollar’s appeal is the Federal Reserve’s aggressive campaign to raise interest rates to tackle decades-high inflation. This has made American investments more attractive as they now offer higher returns.

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

About half of international trade is invoiced in dollars, piling up bills for manufacturers and small businesses that rely on imported goods. Governments that have to pay their debts in dollars can also run into trouble, especially if reserves are depleted.

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

A shortage of dollars in Sri Lanka contributed to the worst economic crisis in the country’s history, ultimately forcing its president out of office last month. The Pakistani rupee plunged to a record low against the dollar in late July, pushing it to the brink of bankruptcy. And Egypt, battered by rising food prices, is grappling with depleted dollar reserves and outflows of foreign investment. All three countries had to turn to the International Monetary Fund for help.

“The environment has been challenging,” said William Jackson, chief emerging markets economist at Capital Economics.

The US dollar tends to rise in value when the US economy is very strong or, somewhat counterintuitively, when it is weak and the world is facing a recession.

In both situations, investors view the country’s currency as an opportunity to hold onto growth or as a relatively safe place to park money until they weather the storm.

The phenomenon is often called the “dollar smile” because it rises at both extremes.

But the rest of the world is left with fewer reasons to smile. Manik Narain, head of emerging market cross-asset strategy at UBS, identified three main reasons why a stronger dollar could hurt the world’s smaller economies.

1. It can add fiscal strain. 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 if the value of the dollar rises, it makes it more expensive to pay off their debts, draining government coffers.

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

This happened when the value of the Sri Lankan rupee collapsed against the dollar earlier this year. The government has drained its foreign reserves, which were already low in part due to a drop in tourism during the pandemic. Then the shortage of essential goods drove thousands of people into the streets. President Gotabaya Rajapaksa fled the country and resigned in July after angry protesters occupied government buildings.

2. Fuels capital flight. When a country’s currency weakens dramatically, wealthy individuals, companies and foreign investors begin to withdraw their money, hoping to stash it somewhere safer. This pushes the currency further down, exacerbating fiscal problems.

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

3. Weighs growth. If businesses can’t afford the imports they need to run their businesses, they won’t have as much inventory. This means they won’t be able to sell as much even if demand remains stable, weighing on economic output.

With the US economy moving forward, that could soften some of the blow. Many emerging markets export goods to the world’s largest economy. But when the dollar strengthens because America is on the brink of recession? This is difficult.

“This could cause more pain in the markets as you don’t have the good padding of better economic growth in the background,” Narain said.

The dollar is down 0.6% in the past week. But it is not expected to meaningfully reverse course anytime soon.

“We expect the dollar’s strength to remain largely intact in the near to intermediate term,” Scott Wren, senior global market strategist at Wells Fargo Investment Institute, wrote in a recent note to clients.

This has investors and politicians wondering if Sri Lanka is just the first domino to fall. There is also the risk that turmoil in emerging markets will spill over into the financial ecosystem, triggering a wide range of knock-on effects.

Brad Setser of the Council on Foreign Relations wrote recently that he observes Tunisia struggling to meet its budget needs, as well as Ghana and Kenya, which are heavily indebted. El Salvador has a bond repayment due early next year, while Argentina continues to struggle after the latest currency crisis in 2018.

The IMF has estimated that 60 percent of low-income countries are in or at high risk of a sovereign debt crisis, up from about a fifth a decade ago.

Volunteers serve free meals to people in need at a community kitchen in Colombo, Sri Lanka, August 4.

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

Dollar-denominated debt is less common than it used to be. The biggest players — such as Brazil, Mexico and Indonesia — “generally haven’t borrowed much in foreign currency and now hold enough foreign exchange reserves to manage their external debt,” according to Setser.

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

Inflation has also prompted central banks in many emerging markets to start raising interest rates earlier than others at the Federal Reserve or the Bank of England. Brazil has raised borrowing costs for 12 consecutive meetings since starting the process in March 2021.

Still, much may depend on the fate of the world’s two largest economies: the United States and China. If these growth engines do start to stall, then emerging markets could witness a painful outflow of investment.

“It will be critical 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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