Why you need to understand the US Dollar's supersurge

There has been no shortage of pundits that have predicted the impending demise of the US dollar in recent times. Its use as a reserve currency is diminishing, they say. The so-called ‘petrodollar’ system, the use of US dollars to transact in oil, is outdated and is no longer relevant for the current world economy.

But this article isn’t meant to be a discussion about the stature of US dollar as a reserve currency. Reserve currency or not, it doesn’t stop cyclical fluctuations, and exchange rates will depend on the economic conditions of the time.

Despite the naysayers, the US dollar index (its value against a basket of currencies) is currently at its highest in 20 years.

The reasons for US dollar strength make economic sense. The US Federal Reserve is lifting official interest rates at a much faster pace than any other central bank. Economic growth prospects for the US continue to be relatively more favourable than net energy importers such as Europe and Japan and other parts of Asia. Additionally, while risk appetite is weak and investors jittery, the US dollar tends to outperform.

But a strong US dollar isn’t good news for everyone, and it means weaker currencies for everywhere else in the world.

For investors, that means a hit to revenues for global US-based firms, and more expensive US assets compared to elsewhere in the world. Investors should also be aware that a strong US dollar could also spell more turmoil in financial markets. 

A big problem for the global economy comes from potential stresses in emerging economies. These economies issue a portion of their debt in US dollars, and so tighter Fed policy and a stronger US dollar means the cost of that debt increases. The problem is exacerbated by capital outflows as investors shun risk. In the past, a Fed tightening cycle, coupled with a stronger US dollar preceded the Latin American debt crisis of the 1980s and the Asian Financial Crisis in 1997-98.

While many emerging economies have learnt lessons from the past and increased foreign reserves since, there are still many which are vulnerable. Earlier this month, the IMF’s Managing Director, Georgieva said that 25% of emerging markets are in or near debt distress, and over 60% are in debt distress in low-income countries. Sri Lanka and Zambia are some countries which have required bailout or debt restructuring recently, and there is an added complication in that China has become involved in these negotiations as a big lender to some of these countries.

The strong US dollar is also causing problems in other economies as well.

Among major economies, the Japanese government has been one of the most vocal and forceful in their concerns about yen weakness. On September 22, Japanese authorities announced they had intervened in the FX market to support the yen.

Recently, Chinese authorities have also expressed concern regarding the yuan. After the yuan depreciated past 7 yuan to the dollar last week, Chinese State media have done their best to talk up the value of the yuan. Further, China’s central bank, the People’s bank of China, held off from further monetary easing on September 20, despite widespread downside risks in the economy.

In many cases, a country with a depreciating currency which is concerned about its economic growth outlook should welcome a weaker currency. A weaker local exchange rate boosts the competitiveness of exports and provides support for the economy. However, it creates a bigger cost on businesses and consumers which rely on imports, which are facing the burden of higher commodity prices. There is also the concern of the rising cost of US dollar-denominated debt as mentioned earlier.

So, with all of these problems arising from the strong US dollar, can anything be done about it? In other words, could we see authorities join with the Bank of Japan in an attempt to intervene in FX markets?

While the yen did jump upon the announcement of the intervention, this move is likely to be short-lived. Further attempts to intervene cannot be ruled out, but the Japanese government is not in a position to have a meaningful long-term impact in FX markets through direct intervention. Nor is any government – on their own. The FX market is just too large. The Bank of International Settlements (BIS) estimated US$6.6 trillion in turnover per day in foreign exchange markets in 2019. Japan’s total foreign currency reserves was just shy of US$1.2 trillion as of August.

It would help if there was a joint coordinated effort to stem the US dollar’s rise. So far, there hasn’t been too much political support for such a move.

Moreover, a globally coordinated FX intervention would only really work beyond the short-term if currency moves are deemed excessive and out of line with economic fundamentals. But while US interest rates continue to rise at a faster pace than everywhere else, it is hard to argue that a misalignment of fundamentals exists. In Japan’s case, FX intervention also works against their own central bank which is maintaining an extremely easy monetary policy stance. In all likelihood, Japan’s intervention and any further attempts at intervening would unlikely have a lasting impact on the yen while the BOJ fails to shift its policy.

There is one other scenario in FX intervention would make sense, and that is if we were to see a major collapse in risk appetite or market function. If there were significant dislocations within financial markets such that liquidity needs to be restored, then that could be seen as justification for FX intervention. However, this kind of intervention isn’t designed to shift currency values, it is more to provide liquidity when markets cease to operate effectively. Such a move would only likely be required in a crisis situation.

In the meantime, while the US Federal Reserve is busy raising interest rates ahead of everywhere else, its economic outlook is relatively favourable, a successful FX intervention does not seem likely, at least over the longer-term. Those wanting a weaker US dollar will just have to wait for the global economic outlook to improve, the Fed to ease off from hiking and for risk appetite to lift substantially.  

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