The writer is President of Queen’s College, Cambridge and Chancellor of Allianz and Gramercy
With so much going on in the global economy and financial markets, the dollar’s recent strong rally has attracted less attention than expected given historical experience.
Theoretically, the appreciation of the currency of the world’s most economically performing companies should help them adjust to the global economy. It helps boost exports from weaker countries while relieving inflationary pressures in the United States by lowering the cost of imports.
But in the current circumstances, there are risks of a rapid appreciation in the dollar both for the well-being of the already volatile global economy and unstable financial markets.
Since the start of the year, the dollar has appreciated about 10 percent as measured by DXY, a widely followed indicator of the currency’s global value. While it was a remarkably broad-based move involving the currencies of the vast majority of economies, the 12-month overall rise of 16 percent in the index brought the index to levels not seen in 20 years.
Three factors come into play: expectations that the Federal Reserve will raise interest rates more aggressively than other central banks in the developed world; superior economic performance of the United States attracting capital from the rest of the world; and the attractiveness of the relative haven of its financial markets.
So far, there has been little political rollback from the development that is undermining the competitiveness of the United States and contributing to its record trade deficit. In the past, such rises in the dollar have threatened trade wars. Now the strong US labor market faced potential tensions.
However, the lack of US political hostility over the dollar’s rise does not mean it is sailing smoothly for global economic and financial stability. The risks are particularly acute for developing countries that already face the clear and present dangers of crises to the economy, energy, food and debt.
For most, a rising dollar translates to higher import prices, an increase in the cost of servicing foreign debt, and an increased risk of financial instability. It is placing more pressure on countries that have already drained their resources and policy responses by combating the scourge of Covid.
The concern is particularly acute for low-income countries, which are also hampered by high food and energy price inflation. The cost of living crisis here also poses a threat of starvation to the most vulnerable.
If I were allowed to burn more, what I called “Little Fire Syndrome Everywhere” – that is, multiplying economic and financial instability in countries – could coalesce into a larger and more dangerous mix of damaged global growth, debt defaults, social, political and geopolitical instability.
The indirect repercussions for advanced economies are likely to be more problematic than any direct effect on them of the appreciation of the dollar. In addition to weakening these economies’ external growth drivers at a time of rising stagflation at home, a turbulent developing world can add volatility to financial markets that are already dealing with multiple risks.
Financial markets have already had to contend with a significant increase in interest rate risk due to the persistently high inflation that has caused the Federal Reserve to infiltrate significantly. In the process, turmoil in government bonds has spread to other market sectors as concerns grow about tightening financial conditions. Now the markets have to worry more about slowing global economic growth.
As alarming as this year’s wealth destruction has been, its impact on economic activity has been mild and the market performance risks have not yet begun. Having said that, for those with sharp noses, there is actually some smell from this due to the cipher massacrealong with frequent price gaps in global benchmarks for the US Treasury market.
Even if this develops into something larger due to the payments turmoil in the developing world, the Fed will find it difficult to return to its usual policy of flooding markets with liquidity given its ballooning balance sheet and inflationary concerns.
The way to reduce the risks associated with a very rapid appreciation of the dollar is for the rest of the world to advance faster with structural reforms that boost growth and productivity, improve capital returns, and increase economic resilience.
Without it, the theoretical promise of orderly global adjustment, including external reinforcements to underperforming countries, would become a difficult source of economic and financial instability.