Je US dollar has been on a major surge against major global currencies over the past year, recently reaching levels not seen in 20 years. It gained 15% against the British pound, 16% against the euro and 23% against the Japanese yen.
The dollar is the world’s reserve currency, which means it is used in most international transactions. As a result, changes in its value have implications for the entire global economy. Below are five of the main ones.
US dollar strength 1977-2022
1. Even more inflation
Gasoline and most commodities such as metals or lumber are usually traded in US dollars (although except for exceptions). So when the dollar strengthens, these items cost more in local currency. For example, in sterling, the price of petrol per $100 has risen from £72 to £84 over the past year. And as the price of a liter of petrol in U.S. dollars also increased sharply, this creates a double whammy.
When energy and raw materials become more expensive, the prices of many products rise for consumers and businesses, causing inflation around the world. The only exception is the United States, where a stronger dollar makes it cheaper to import consumer goods and could therefore help keep inflation in check.
2. Low-income countries at risk
Most developing countries owe their debt in US dollars, so many owe significantly more today than they did a year ago. As a result, many will struggle to find an ever-increasing amount of local currency to pay off their debts.
We already see it in Sri Lankaand other countries may soon do the same. They will either have to tax their savings more, issue inflationary local currency, or simply borrow more. The results could be a deep recession, hyperinflation, sovereign debt crisis, or all three, depending on the path chosen. Developing countries that fall into sovereign debt crises can take years or even decades to recover, causing serious hardship to their people.
3. A larger US trade deficit
Other countries will buy fewer American products because of the strong dollar.
The US trade deficit, which is the difference between the amount of exports and imports, is already close to a mammoth trillion dollars per year. President Joe Biden and donald trump before him swore to reduce it, especially against China. Some economists worry that the trade deficit is causing the United States to borrow and reflects the fact that many manufacturing jobs have moved overseas.
US trade deficit as % of GDP
4. De-globalization will get worse
The most obvious economic policy to keep a trade deficit from widening is the old game of imposing tariffs, quotas or other barriers to imports. Other countries tend to retaliate against such protectionism, adding their own taxes and other barriers to American products. At a time when De-globalization has already begun thanks to deteriorating Western relations with Russia and China, a stronger dollar adds political momentum for protectionism and threatens global trade.
5. Eurozone fears
Weaker EU Member States such as Portugal, Ireland, Greece and Cyprus have become somewhat less vulnerable to investors pushing their borrowing costs to crisis levels than during the darkest days of the Eurozone crisis. This is because much of their national debt is now in the hands the European Stability Mechanism (ESM), which was set up to help rescue them, as well as friendlier investment banks within the Eurozone.
However, the stronger the dollar create pressure that the European Central Bank raises its own interest rates to support the euro and control the cost of imports, including energy. This will put more pressure on highly indebted eurozone countries. Italy, which is the ninth largest economy in the world and has a public debt of 150% of GDP, would be particularly hard bail out if the situation got out of control.
By bringing together these five points, the ultra-strong dollar is yet another reason fear a global recession in the coming period. Higher inflation erodes consumer incomes and reduces consumption. Protectionism can reduce international trade and investment. Sovereign debt crises mean serious problems for many developing countries and perhaps even for the Eurozone.
Will the dollar continue to rise?
The dollar rose for both economic and geopolitical reasons. The central bank of the United States – the Federal Reserve – raised its interest rates aggressively and also reversed its monetary creation policy via quantitative easing (QE). This is in an effort to curb inflation caused by COVID supply issues, the war in Ukraine and also QE.
The appreciation of the US dollar is a side effect of these higher interest rates. Because the dollar now offers a higher return when deposited in a US bank, it encourages foreign investors to sell their local currency and buy US dollars.
Of course, central banks in other jurisdictions like the UK have also raised interest rates, and the Eurozone plans to do the same. But they are not acting as aggressively as the United States. Meanwhile, Japan is not tightening at all, so the net result is still greater foreign demand for greenbacks.
The other reason for the surge in the US dollar is that it is a classic safe haven when the world worries about a recession – and the current geopolitical situation arguably makes it even more attractive. The euro suffered from the EU’s proximity to the war in Ukraine, its exposure to Russian energy and the prospect of another eurozone crisis. It is close to dollar parity for the first time since its early years.
The pound has been hit by Brexit and also faces the prospect of a second Scottish independence referendum and a potential trade war with the EU on the Northern Ireland protocol. Finally, the yen belongs to an economy that seems to be slowly losing ground. Japan is aging and is still not comfortable with the migration to increase its production capacities. A weaker yen is also the price that Japan pays for continued QE to keep interest rates low on its public debt.
It is difficult to predict the future direction of the US dollar when there are so many moving parts in the global economy. But we suspect that persistent inflation will force US interest rates to keep rising and that, combined with the geopolitical shocks of war and sovereign debt defaults, will likely keep the dollar high. A strong US dollar is an answer to troubled times.
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