US dollar’s unchecked dominance imperils emerging markets – and surprisingly its own economy

15 Sep 2022

With multilateral collaboration no longer the go-to strategy in times of trouble, the likelihood of the G7 banding together to rein in the US dollar’s rampage is slim. That doesn’t just expose emerging markets to the risk of a 1998-style crisis, but also has adverse ramifications for the advanced countries – and the US.

The dollar is running rampant on the global foreign exchange stage, but, unlike previous periods when countries rallied against the greenback’s ascension, it’s unlikely to be reined in any time soon.

The world’s reserve currency, which has experienced double-digit gains so far this year, gathered further momentum in the wake of the latest headline consumer inflation figures, which were a sore disappointment for investors who expected them to convince the US Federal Reserve that inflation was on a convincing downward trajectory.

Coming in at 8.3% instead of the expected 8.1%, markets saw the broadening in price pressures – which negated the fall-off in oil prices – as likely to intensify the Fed’s hawkish stance. Calls for a 100 basis point (bp) rate hike ensued, putting paid to hopes that the next rate hike would be 50 bps instead of the 75 bps factored in ahead of the data release.

The dollar is now approaching all-time highs after reaching 20-year highs against other major currencies, sending the pound to below its 1985 low and the euro to below parity for the first time since 2002.

Though the rand also retraced some of its recent gains ahead of the inflation data, it is holding up better than other emerging market currencies because it is a major exporter of coal, which is in high demand.

After strengthening to R17.11 to the dollar ahead of the US CPI release, the domestic currency has weakened to R17.50 as a result of the tide of risk aversion that has set in again.

The dollar has several forces in its favour, including its earlier and more aggressive interest rate hikes than its advanced country counterparts, and the flight to safety that has held firm in the face of the plethora of geopolitical and macroeconomic travails.

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We are unlikely to see an imminent turnaround in these strong tailwinds, driving the US currency higher. The dollar is only expected to lose ground if the US moves into a recession, prompting the Fed to release the reins on its monetary stance and evening out the macroeconomic imbalances between the US and the rest of the world.

To date, the US’s safe haven status has been secured by its remoteness from the Ukraine-Russia war, its robustly stronger economy, and its relative energy independence compared with Europe’s dependence on Russian gas and the UK’s spiralling energy costs.

It’s historically unusual for the dollar to have been allowed to rally this much. The only other time that the dollar dominated to this extent was in the early 1980s, and then the Group of Five nations (G5) banded together to put the brakes on the greenback, putting in place the unprecedented 1985 Plaza Accord, which was an agreement to jointly intervene in the foreign exchange markets by selling dollars.

Though Japan has become more vocal over the last week about its dissatisfaction with the impact a strong dollar is having on its economy, Atlantic Council GeoEconomics Center programme assistant Mrugank Bhusari says in an article titled, “Don’t expect a Plaza Accord 2.0 to reverse the dollar’s surge”, that it is unlikely that the global powers will agree on similar coordination again.

He argues that neither China nor the original participants of the Plaza Accord would be willing to engage in such an agreement today because there is no political will. This is evidenced by US Treasury Secretary Janet Yellen’s recent remarks in favour of relying on market exchange rates to determine the value of the dollar, and the G7 commitment to non-intervention in May this year.

It’s unlikely that Japan or any of the emerging markets will act alone, given they don’t have sufficient reserves to turn the tide of the mighty dollar.

In the absence of intervention, Morgan Stanley spells out the risks of the “extreme relative dollar strength”.

Lisa Shalett, Chief Investment Officer of Morgan Stanley Wealth Management, says it “could lead to bouts of instability, similar to the market-based 1997 Asian debt crisis or the mounting trade imbalances that led to the 1985 Plaza Accord, in which the US agreed to weaken the dollar to reduce those imbalances”.

But she notes that investors don’t seem to appreciate the risk, and that market-positioning data show investors around the world still favour the dollar and expect its strength to persist.

Shalett also warns that the strength of the greenback exposes the US to specific risks, namely currency extremes threatening corporate earnings and putting US companies’ competitiveness at risk, US financial assets becoming less attractive to foreign investors, and the strong dollar contributing to the US’s already gaping $1-trillion trade deficit when total US debt is already well over 100% of GDP.

Emerging markets typically bear the brunt of a strong dollar, though, and Old Mutual Multi-Managers investment strategist Izak Odendaal highlights the adverse impact the reserve currency has on dollar-borrowers, including the Chinese property developers who are exposed to about $200-billion in dollar-denominated debt.

Historically, periods of dollar strength have been followed by emerging market crises. Think the emerging market crisis in the late 1990s, and Odendaal points out that many developing countries, including Sri Lanka, Pakistan and Zambia, are already in trouble and negotiating emergency packages with the IMF.

“Expect more in the months ahead, particularly involving net food and energy importers,” he warns.

Odendaal argues that the two main reasons we haven’t yet experienced a broader emerging market crisis are that emerging markets have learned from previous crises and abandoned unsustainable policies such as offshore borrowing, currency pegs and fuel subsidies, and several emerging markets, including SA, have benefitted from the higher energy prices.

However, with sustained dollar strength likely for the foreseeable future and little sign of an improvement in global macroeconomic forces, these risks are material, and any further bad news or unwelcome surprises could prove the tipping point for already jittery and liquidity-strapped financial markets. BM/DM

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