Strong USD is hurting the whole world

This year, the USD has gained more than 10% against other major currencies, threatening the growth and finances of many economies.

Investors are increasingly buying USD on recession fears, as the currency is seen as a haven in times of volatility. In addition, the US Federal Reserve (Fed) continuously raised interest rates strongly to tackle the 40-year high inflation. This makes investing in the US even more attractive, because it gives higher returns.

American tourists can feel happy when an evening in Rome that once cost 100 USD is now only 80 USD. However, the picture with foreign governments and multinationals is much more complicated.

About half of the world's trade is in USD. As a result, costs for manufacturers and small businesses that depend on exports are being inflated. Governments that need to repay their debt in dollars are also in trouble, especially if their foreign exchange reserves are low.

The appreciation of the USD has had some obvious effects. In Sri Lanka , a shortage of dollars contributed to one of the country's worst economic crises , forcing the President to leave the country. In Pakistan, the rupee is hitting a record low against the dollar, pushing the country to the brink of default. Egypt - already reeling from rising food prices - must further deal with a drop in US dollar reserves and a withdrawal of foreign investment. All three countries had to look to the International Monetary Fund (IMF) for help.

"The current environment is very challenging," said William Jackson, chief economist at Capital Economics.

USD recently continuously appreciated against major currencies. Photo: Reuters

USD tends to appreciate when the US economy is very strong, or the US economy is weak and the whole world faces a recession. In both cases, investors see the coin as an opportunity for growth, or as a safe haven. This phenomenon is known as the "dollar smile", because it appreciates in both scenarios.

However, the rest of the world is not so happy. There are three main reasons why a strong dollar hurts small economies, says Manik Narain, director of cross-commodity strategy for emerging markets at UBS.

Cause financial stress

Not all countries have the ability to borrow in their local currency, as foreign investors may not have confidence in the country's institutions or finances. This means they have no choice but to issue bonds in USD. When the dollar price increases, the debt mass of countries will also become heavier, causing their reserves to decrease.

It also costs countries more to import food, medicine, and fuel. This is precisely the case with Sri Lanka. The rupee has plummeted against the dollar this year. Their foreign exchange reserves, which were already at a low level due to tourism stagnation during the pandemic, are now drained. The lack of necessities caused people to take to the streets to protest. Former President Gotabaya Rajapaksa resigned and left the country last month.

Make capital flow out of the country

When a country's currency weakens significantly, the rich, foreign companies and investors begin to withdraw money from the country in search of safer places. This situation causes the price of that currency to fall further, exacerbating financial problems.

"If you're in Sri Lanka and you see the government under pressure, you'll want to move the money," Narain said.

Putting pressure on growth

If companies can't import the goods they need to operate, they won't have enough products. This means not selling much, even when demand is high, and will put pressure on economic growth.

When the US economy stabilizes, this impact will be mitigated, because countries can export goods to this country. However, in the event of a strong USD when the US is on the verge of a recession, all will be in trouble.

Last week, the USD fell 0.6% against a basket of major currencies. However, the current situation is unlikely to reverse anytime soon.

"We think the dollar will continue to be strong in the medium term," said Scott Wren, global market strategist at Wells Fargo Investment Institute. This has many investors and policymakers wondering if Sri Lanka is just the beginning. The risk of volatility in emerging markets could spill over into the global financial system.

Brad Setser at the CFR recently said he is watching Tunisia - which is struggling on a budget - and Ghana, Kenya - which currently has a large amount of debt. El Salvador also has to repay its bonds early next year. Argentina is still struggling since the 2018 currency crisis .

The IMF estimates that about 60% of low-income countries are at risk of public debt. This rate 10 years ago was only 20%.

However, the current situation is also very different from past crises. Bonds issued in USD are not as popular as they used to be. Heavy borrowers, such as Brazil, Mexico and Indonesia, "generally don't borrow much in foreign currency and have enough foreign exchange reserves to pay off their debt," Setser said.

Besides, prices of commodities from oil to base metals remain high. This will help emerging economies have a stable source of foreign currency earnings through exports.

Inflation also prompted central banks in emerging countries to raise interest rates earlier than in the US or UK. Brazil started this process in March 2021 and has so far raised profits 12 times in a row.

However, the situation still depends on the future of the world's two largest economies, the US and China. If these two growth engines slow down, capital flows will leave emerging markets.

"Whether the US falls into a recession or not is the important issue," said Robin Brooks, an economist at the Institute of International Finance (IIF), "It will make people more risk-averse."