US travelers may be happy that a night out in Rome that used to cost $100 is now around $80, but the situation is more complicated for multinationals and foreign governments.
A stronger dollar is already hitting some fragile economies.
“It’s a tough environment,” said William Jackson, chief emerging markets economist at Capital Economics.
Why the ‘dollar smile’ is frowned upon
The US dollar tends to appreciate when the US economy is doing very well, or, somewhat counterintuitively, when the economy is weak and the world is facing a recession.
In both situations, investors see their currency as an opportunity to lock in growth or a relatively safe place to store cash while they weather the storm.
This phenomenon is often referred to as the “dollar smile” because it rises on both extremes.
But the rest of the world has less to grin on. Manik Narain, head of cross-asset strategy for emerging markets at UBS, identified three main reasons why a stronger dollar could hit the world’s smaller economies.
1. Potential financial burden. Not all countries can borrow money in their own currency. Either foreign investors do not trust their institutions or the financial markets are underdeveloped. In other words, some countries have no choice but to issue dollar-denominated government bonds. But a sharp rise in the value of the dollar would lead to higher debt service payments and exhaust government coffers.
It also increases the cost for governments and businesses to import food, medicines and fuel.
2. Facilitate capital flight. When a country’s currency drops dramatically, wealthy individuals, businesses and foreign investors start withdrawing their money, hoping to keep it in safer places. It depresses the currency further and exacerbates the financial problems.
“If you are in Sri Lanka right now and you see the government under pressure, you want to make money.
3. Become a growth burden. If a company can’t afford to buy the imports it needs to run its business, it doesn’t have that much inventory. It will put pressure on economic output.
If the U.S. economy is doing well, we can soften some of the blow. Many emerging markets export goods to the world’s largest economies. But when will the dollar rise as America is on the brink of recession? It is tough.
“The lack of positive signs of improving economic growth in the background could cause further damage to the market,” Narain said.
contained the crisis
The dollar has pulled back 0.6% over the past week. But it’s not expected to reverse course meaningfully any time soon.
“We expect the dollar to remain largely unchanged in the short to medium term,” Scott Ren, senior global market strategist at Wells Fargo Investment Institute, said in a recent note to clients.
This has led investors and policy makers to ask themselves if Sri Lanka is just the first domino to fall. There is also the risk that turmoil in emerging markets will spread across the financial ecosystem, causing widespread ramifications.
But there are also important differences between the current situation and past crises.
Dollar denominated debt is no longer as common as it used to be. The largest players, such as Brazil, Mexico and Indonesia, “do not typically borrow much in foreign currency and currently hold sufficient foreign exchange reserves to manage their external debt burdens,” Setser said. increase”.
In addition, commodity prices such as oil and base metals remain high. This serves as a reliable way to help emerging economies that are major exporters, including much of Latin America, and ensure that dollars continue to flow into government coffers.
Even so, the fate of the world’s two largest economies, the United States and China, could very well depend. If these growth engines really start to falter, emerging markets could see a painful outflow of investments.
Robin Brooks, chief economist at the Institute of International Finance, said: “What matters is whether the U.S. goes into recession. “Everybody becomes more risk-averse.”
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