The world can survive a strong dollar - for now

LONDON, May 14 (Reuters Breakingviews): The dollar is casting a long shadow over the world. The US currency has surged on the back of American economic resilience and higher interest rates. Prudent fiscal management and less foreign currency debt has helped to insulate most countries from the effects of this imbalance. But if the greenback keeps rising, commodity importers and emerging markets have a lot to worry about.
The dollar is on a tear. An index that tracks its value against a weighted basket of currencies of major US trading partners has risen by around 17 per cent since 2021. This year alone, the greenback is up 10 per cent against the Japanese yen, nearly 8 per cent relative to the Swedish crown and almost 2 per cent compared with the Chinese renminbi, despite Beijing's tight foreign exchange controls.
The surge is largely due to the extraordinary economic performance of the United States. Since 2021, US GDP has grown at an average of 3.4 per cent a year. That's more than double its cruising speed between 2006 and 2015, and 70 per cent faster than a group of advanced economies in the 13 years before the pandemic, International Monetary Fund data show. Inflation pressures prompted the Federal Reserve to raise interest rates and hold them at a high level, increasing the attractiveness of dollar-denominated assets for investors.
In previous cycles, such a sharp upward move in the dollar could have damaged countries that relied on the United States to grease their economic wheels. The most devastating example was the Asian financial crisis that started in 1997. Countries like Thailand, Malaysia and Indonesia failed to defend fixed exchange rates, leading to capital flight and long recessions.
There are two main reasons other countries have avoided the doom loop this time. First, the twin inflationary shocks of the pandemic and Russia's invasion of Ukraine hit around the world, prompting central banks to hike interest rates at roughly the same time, lowering the risk of capital flight. Indeed, some central banks began tightening monetary policy before the Fed. Brazilian policymakers started raising rates in March 2021 - a year before their US counterparts. Official borrowing costs in the country are now 10.5 per cent, nearly double the level in the United States.
Many emerging markets had also put their fiscal houses in order. The biggest difference with the past has been the sharp increase in the percentage of debt issued in local currencies. Domestic-denominated debt accounted for 95 per cent of the $3.9 trillion in new borrowing by governments in emerging markets last year, according, opens new tab to the Organisation for Economic Co-operation and Development.
The differences with the past couldn't be starker. In 1996, nearly a third of Thailand's stock of long-term debt was in dollars, research, opens new tab by the Reserve Bank of Australia found. Today it's less than 1 per cent, according to a Breakingviews analysis of data by the Institute of International Finance. Brazil's dollar debt has shrunk from 69 per cent of outstanding borrowings to 4 per cent over the same period. Overall, government debt denominated in dollars is equivalent to just 2 per cent of GDP in Asia's emerging economies and 10.5 per cent of GDP for emerging markets in Latin America, excluding Argentina, IIF data show.
But that won't insulate other countries from a strong dollar forever. If the greenback keeps rising - because the Fed keeps rates high or even raises them further, or because another unexpected event jolts the world - cracks could appear in the global economy. The most worrying consequence would be a debt crisis in emerging markets. Even though many countries now borrow in their own currencies, much of the debt is still in foreign hands. A Bank for International Settlements study, of 25 emerging markets found that in 2021 foreigners held more than 12 per cent of outstanding domestic government debt.
That percentage rises above 25 per cent once foreign currency debt is included. These investors could flee at a moment's notice.
That's what happened at the start of the pandemic in March 2020, when fund managers fled for the safety of US government bonds. As the dollar surged, US investors with large holdings of domestic sovereign bonds reduced them by 10 per cent for longer-dated bonds and nearly 6 per cent for shorter-dated debt, according to another BIS study, opens new tab of 16 emerging markets.
Yields on 10-year Brazilian government bonds spiked from 6.6 per cent to 9.8 per cent in less than a month. "We were able to switch our external debt for local debt, and everybody said: 'Okay now you don't have any fragility on the dollar anymore', but that's not entirely true," the governor of Brazil's central bank Roberto Campos Neto said at the IMF meetings in Washington last month. "Guess who buys the internal debt? The foreign investor."
For countries that rely on imported goods, especially commodities, the negative effects of the strong dollar could be even worse. It is unusual for the two to rise in tandem - during the two Gulf Wars in 1990 and 2002, for example, oil prices rose but the dollar fell. But in the past three years, an index of commodity prices compiled by S&P Global has gained nearly 3.5 per cent. If that pattern continues, economies like the euro zone and Japan will suffer a double whammy of depreciating currencies and higher costs for dollar-denominated commodities.
Poorer countries, such as those in sub-Saharan Africa, have also a lot to lose from a stronger-for-longer greenback. That's because they do not have much access to international capital markets and depend on loans that are often denominated in dollars. Some, like Ghana, which defaulted on most of its external debt in 2022, are already struggling.
"If major central banks' monetary policies remain restrictive for some time, it would naturally have an impact on relative currency strength," Carmine Di Noia, Director for Financial and Enterprise Affairs at the OECD, says. "The risk of foreign currency debt distress should be carefully monitored."
Of course, if the Fed starts cutting rates in response to weaker inflation or slower economic growth, the dollar could decline. But emerging markets have already lowered their borrowing costs, and the euro zone may start in June, so the greenback is likely to
offer more attractive returns than other currencies for a while. Until the
dollar comes back down to earth, the rest of the planet will have to be on high alert.