The US dollar has on a big increase against major global currencies over the past year, recently reaching levels not seen in 20 years. It is up 15 percent against the British pound, 16 percent against the euro and 23 percent against the Japanese yen.
The dollar is the world’s reserve currency, meaning it is used in most international transactions. Consequently, changes in its value affect the entire world economy. Below are five of the most important.
Even more inflation
Gasoline and most commodities such as metals or lumber are usually traded in US dollars (although with exceptions). As the dollar strengthens, these items will cost more in local currency. In British pounds, for example, the cost of US$100 worth of petrol has risen from £72 to £84 over the past year. And since the price per liter of gasoline in US dollars has risen sharply, there is a double whammy.
When energy and raw materials become more expensive, the prices of many products rise for consumers and businesses, causing global inflation. The only exception is the US, where a stronger dollar makes importing consumer goods cheaper and could therefore help tame inflation.
low-income countries at risk
Most developing countries owe their debt in US dollars, leaving many with much more debt today than they were a year ago. As a result, many will struggle to find increasing amounts of local currency to service their debts.
We already see this in Sri Lankaand other countries can soon follow. They must either tax their economies more heavily, spend inflationary local money, or simply borrow more. Depending on the path chosen, the consequences can be a deep recession, hyperinflation, a sovereign debt crisis or all three together. Developing countries falling into sovereign debt crises can take years or even decades to recover, causing severe hardship to their people.
A larger US trade deficit
Other countries will buy fewer US products due to the strong dollar. The US trade deficit, which is the difference between the amount of exports and imports, is already approaching a mammoth a trillion dollars per year. President Joe Biden and donald trump before him promised to reduce it, especially towards China. Some economists worry that the trade deficit is driving up US borrowing and reflects the fact that many manufacturing jobs have been offshored.
Deglobalization is getting worse
The most obvious economic policy to prevent a trade deficit from growing is the old game of imposing tariffs, quotas or other barriers on imports. Other countries tend to retaliate against such protectionism by adding their own taxes and other barriers to US products. At a time when “Deglobalization” has already begun Thanks to the deteriorating western relationship with Russia and China, a stronger dollar increases the political momentum for protectionism and threatens global trade.
Weaker EU member states such as Portugal, Ireland, Greece and Cyprus have become somewhat less vulnerable to investors driving borrowing costs to crisis levels than they were in the darkest days of the eurozone crisis. This is because much of their national debt is now in hands the European Stability Mechanism (ESM) put in place to rescue them, and friendlier investment banks within the eurozone.
However, the stronger dollar generate pressure that the European Central Bank will raise its own interest rates to support the euro and lower import costs, including energy. This will increase the pressure on eurozone countries with high levels of debt. Italy, which is the ninth largest economy in the world and has public debt a whopping 150 percent of GDP, would particularly hard exit if the situation gets out of hand.
Putting these five points together is the ultra strong dollar yet another reason to fear a global recession in the coming period. Higher inflation cuts consumer incomes and reduces consumption. Protectionism can reduce international trade and investment. Sovereign debt crises mean serious problems for many developing countries and possibly even for the eurozone.
Will the dollar continue to rise?
The dollar has risen for both economic and geopolitical reasons. The central bank of the United States – the Federal Reserve – has aggressively raised interest rates and also reversed its policy of printing money over the internet quantitative easing (QE). This is in view of curbing inflation caused by supply issues from Covid-19, the war in Ukraine and also QE.
The stronger US dollar is a side effect of these higher interest rates. Because the dollar now offers a higher yield when deposited with a US bank, it is encouraging foreign investors to sell their local currency and buy US dollars.
Of course, central banks in other jurisdictions like the UK have also hiked rates, and the eurozone plans to do the same. But they are not acting as aggressively as the USA. Meanwhile, Japan is not tightening at all, so the net result is still greater foreign demand for greenbacks.
The other reason the US dollar has risen is that it’s a classic safe haven asset when the world fears a recession – and the current geopolitical situation arguably makes it even more attractive. The euro has suffered from the EU’s proximity to the war in Ukraine, its dependence on and the prospect of Russian energy another crisis in the eurozone. It is close to dollar parity for the first time since its early years.
The British pound has been hit by Brexit and is also facing a second Scottish independence referendum and one possible trade war with the EU via the Northern Ireland Protocol. After all, the yen is part of an economy that seems to be slowly losing ground. Japan is aging and is still not comfortable with migration to increase production capacities. A weaker yen is also the price for this Japan pays for continuing QE to keep interest rates on its sovereign debt low.
It is difficult to predict the future direction of the US dollar when there are so many moving parts in the global economy. However, we suspect that continued inflation will force US interest rates to rise further and that combined with geopolitical shocks from war and sovereign debt defaults will likely keep the dollar elevated. A strong US dollar is a reaction to troubled times.
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