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Why the US dollar’s supremacy is hurting the rest of the world

The foreign exchange market has been roiled by government interventions in Japan and the United Kingdom, while the greenback’s strength continues to cause inflationary pressure

JAVIER JAÉN
Álvaro Sánchez

“In God We Trust” has been inscribed on all US paper and coin currency since former president Dwight Eisenhower mandated it in the 1950s. Americans generally believe in the afterlife, but also in their dollar – and they are not the only ones. The currency has become one of the few attractive assets in a global economy threatened by war, recession and an energy crisis. International investors, besieged by plunging stock markets, bonds and cryptocurrencies, are flocking to the US dollar like lost travelers diving into a desert oasis. But its strength against other currencies is having major impacts on governments, businesses and individuals.

Unlike other capital markets, the foreign exchange market is usually not very volatile. Apart from sporadic episodes such as investor George Soros’ 1992 attack on the pound sterling or occasional collapses in emerging economies, currency fluctuations tend to be minor. But that tranquil stability is changing. Interest rate hikes by interventionist central banks have triggered the current foreign exchange volatility, causing the price of money to fluctuate dramatically and plunging national currencies into a competition that has only strengthened the US dollar. The Japanese yen has dropped by more than 20% against the US dollar in a year; the pound sterling and the euro have dropped by more than 15%; and the Chinese yuan by more than 10%, its sharpest decline since 1994.

The US dollar index, which measures its performance against a basket of currencies, is nearly at a 20-year-high. There are several reasons for the US dollar spike. The US Federal Reserve, known as the Fed, began raising interest rates earlier and more aggressively than other central banks. The Fed has set interest rates, or the price of borrowed money, at 3%-3.25%, compared to the European Central Bank’s (ECB) 1.25% rate, which has attracted investors looking for higher yields in the US dollar. The energy crisis brought on by Russia’s invasion of Ukraine, has affected the US less because it is a major producer of natural gas and oil, unlike Europe, which is highly dependent on Russian energy sources. The warning signs of an impending economic slowdown have also fueled demand for the US dollar, which is considered a safe-haven currency like the Swiss franc.

The most obvious impact of a strong US dollar is on prices. “The depreciation of the euro contributes to increasing inflationary pressure by making imports more expensive. Conversely, the appreciation of the US dollar helps curb inflationary pressure in the United States,” stated BBVA Research. In other words, the US is exporting inflation to Europe and the rest of the world through its strong dollar, because agricultural raw materials and energy contracts are quoted in US dollars, which makes purchases of gas and oil even more expensive. Cautionary opinions are also coming from within the United States. The New York Times put it simply: “The Dollar is Strong. That is Good for the US, but Bad for the World.”

Ignacio de la Torre, chief economist at Arcano Economic Research, notes that a strong US dollar has other impacts. “An expensive dollar is generally bad for emerging economies that hold dollar-denominated sovereign debt, but it also makes exports to the US cheaper.” Currency devaluations have traditionally led to greater competitiveness, since they make a country’s exports of products and services cheaper than the competition. But this advantage is being diluted, says Natalia Aguirre, Director of Analysis and Strategy at Renta 4, a Spanish financial institution. “The energy shock that could drag Europe into recession outweighs the benefits of a depreciated euro, especially because external demand is declining due to a global economic slowdown,” said Aguirre. BBVA Research agrees: “In the current context, the weak euro is a cause for concern, rather than an opportunity to export more.”

Governments have not ignored their sinking currencies. The Japanese Finance Ministry recently announced dramatic measures to prop up the yen not seen in more than 20 years. And the Bank of England intervened twice in late September to halt the pound’s plunge and calm markets following the British government’s announcement of a tax-cut plan that would increase government borrowing costs.

Olivia Álvarez, an analyst at Afi Research, believes that the collapse of the pound and financial instability in the UK were triggered by erratic government moves that have even drawn criticism from the International Monetary Fund (IMF). “We are seeing a misalignment between monetary policy and government decisions, with an ultra-expansionary fiscal package that is at cross-purposes for controlling inflation.”

Given all this turmoil, is a global currency crisis at hand? “That statement a little too broad,” said de la Torre, “but it might be true of certain currencies. The three G20 currencies with the worst performance in 2022 are the Argentine peso, the Turkish lira and the British pound.”

A threat to the bottom line

Businesses are not immune to foreign exchange volatility. Although many have financial instruments that protect them from currency fluctuations, others haven’t hedged this risk. Airline companies have to pay for fuel, aircraft and other items in US dollars, and an expensive dollar is hitting their bottom lines hard.

Jorge Labarta, a founding partner of Quant (a foreign exchange consulting firm), said: “We have clients who bought dollars at well below the current price. But when those currency risk hedges run out, they will have to go back to the market to buy future contracts for much more expensive dollars.” Currency risk hedges can also have a downside. For example, conservative exporters that don’t want to expose themselves to the ups and downs of the US dollar are also unable to cash in on the dollar’s appreciation.

US inflation is the key

One of the most obvious benefits of a strong dollar for Americans is that foreign vacations cost much less than a year ago. Conversely, the US is a more expensive vacation destination for the rest of the world, which may dissuade foreign tourists. EU expatriates working in the US who are paid in euros have lost purchasing power, while Americans working in Europe who are paid in dollars have been less affected by the rising cost of living.

For the first time in 20 years, the US dollar is worth more than the euro, and has also risen in value against many other currencies. Uncertainty is at an all-time high for investors, who have to keep a closer eye on currency risk than ever before. The big question is whether the dollar will continue to surge. Labarta says that depends on how inflation in the US evolves. “If it eases, then the Federal Reserve won’t need to raise interest rates further, and since the markets take rate hikes for granted, this will help the euro appreciate. The only events that will reverse the current trend will be a possible end to the war in Ukraine and a clear slowdown in US price increases.” With the recent Russian mobilization of reservists, and the US annual inflation at 8.3% in August – the September rate will be announced in mid-October – neither seem likely in the short term.


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