The author is President of Queens’ College, Cambridge and advisor to Allianz and Gramercy
With so much going on in the global economy and financial markets, the sharp recent appreciation of the dollar has attracted less attention than might have been expected given historical experience.
On paper, the appreciation in the currency of the world’s most resilient economic performer should support adjustments in the global economy. It helps boost exports from weaker countries while alleviating inflationary pressures in the US by lowering import costs.
But under current conditions, a rapid rise in the dollar poses dangers to both the health of an already shaky global economy and troubled financial markets.
Since the beginning of the year, the dollar has appreciated about 10 percent as measured by the DXY, a widely used index of the currency’s global value. In a remarkably broad move that included the currencies of the vast majority of economies, the 16 percent cumulative 12-month appreciation has taken the index to levels not seen in 20 years.
Three factors are at play: expectations that the Federal Reserve will raise interest rates more aggressively than other central banks in advanced economies; US economic performance attracting capital from the rest of the world; and the relative refuge attractiveness of its financial markets.
So far, there has been little political opposition to a development that is undermining US competitiveness and contributing to its record trade deficit. In the past, such rises in the dollar have threatened trade wars. Now America’s strong labor market has counteracted potential tensions.
Yet the lack of political antagonism in the US over the rise of the dollar does not mean it is smooth sailing for global economic and financial stability. The risks are particularly acute for those developing countries that already face the clear and present dangers of economic, energy, food and debt crises.
For most of them, an appreciation of the dollar translates into higher import prices, more expensive external debt servicing, and greater risk of financial instability. It puts further pressure on countries whose resources and policy responses are already strained by fighting the ravages of Covid.
The concern is particularly acute for low-income countries, which are also hampered by high food and energy inflation. A livelihood crisis here is also an impending famine for the most vulnerable.
If left to burn, what I have called the “small fires everywhere syndrome” – that is, the multiplication of instances of economic and financial instability in countries – can result in a larger, more dangerous combination of damaged global growth, debt defaults and social, political and geopolitical instability.
The repercussions on advanced economies are potentially more problematic than any direct impact of dollar appreciation on them. In addition to weakening the external growth drivers of such economies at a time of increasing domestic stagflation, a destabilized developing world can increase volatility in financial markets, which already face numerous risks.
The financial markets have already had to accept a significant increase in interest rate risk due to persistently high inflation, which has massively sidelined the US Federal Reserve. Meanwhile, the disruption in government bonds spread to other segments of the market as concerns over tightening financial conditions began to grow. Now markets need to worry more about slowing global economic growth.
Unpleasant as this year’s wealth destruction has been, its impact on economic activity has been muted and the risk of market functioning remains to be seen. However, for the keen nose, this is already a foreshadowing of the crypto carnage, along with repeated price gaps in global US Treasury market benchmarks.
Even if this were to evolve into something major due to defaults in developing countries, the Fed, with its bloated balance sheet and inflation concerns, would find it difficult to return to its usual policy of flooding markets with liquidity.
The way to mitigate the risks associated with too rapid a dollar appreciation is for the rest of the world to move faster with structural reforms that boost growth and productivity, improve returns on capital, and enhance economic resilience.
Without this, the theoretical promise of orderly global adjustment, including external stimulus for underperforming countries, would become a challenging source of economic and financial instability.