A stronger dollar could hit emerging economies hardest this cycle
The writer is head of emerging markets economics at Citi
Developing countries live their economic lives at the mercy of the US Federal Reserve. This may sound brutal, but it is no less true.
When US monetary conditions are relaxed, capital is pushed into emerging economies, making it easier for these countries to finance themselves. And when the Fed tightens, as it does these days, the tide turns as capital seeks higher returns in the United States.
This cycle is generally understood as resulting from the impact of rising or falling US interest rates on capital flows to developing countries. Yet it is not just the performance of US assets that affects these countries; the dollar exchange rate also plays a big role in this drama.
Here are four ways a stronger dollar is making life difficult for emerging economies.
First, a stronger dollar tends to depress the growth of world trade. It is the dominant currency for invoicing and settlement of a large part of global commercial transactions. Since the purchasing power of non-US currencies declines when the dollar appreciates, an appreciation of the US currency tends to make the world poorer and less engaged in trade.
Since developing countries tend to be what economists call small open economies that are particularly dependent on global trade, anything that puts downward pressure on it is likely to be useless to them.
Second, a stronger dollar tends to erode the creditworthiness of developing countries whose debt is denominated in US dollars. The appreciation of the dollar makes it more expensive for countries to buy the US currency they need to service their debt. This is likely to be most painful for low-income countries which generally have only limited ability to borrow internationally in their own currency, even in the best of times.
Third, a strong dollar is likely to be troublesome for China these days, and what’s bad for that country is generally unnecessary for emerging economies given their ties to Chinese supply chains and demand for raw materials.
While it’s superficially appealing to think that a weakened renminbi could be a practical way to boost Chinese exports, there are two bigger forces at work in the opposite direction.
The first is that by driving up the cost of imported raw materials, a weaker renminbi is making life difficult for small and medium-sized businesses in China, which have faced prolonged pressure on their profitability anyway. And another is that a weakened renminbi tends to trigger capital outflows from China, which authorities in Beijing prefer to avoid as they seek to maintain positive expectations on its currency.
Finally, a stronger dollar today is likely to be more inflationary for emerging economies than was the case in the past. The last few years have allowed us to forget that the depreciation of the currency in a developing country can quickly lead to inflation. Indeed, the so-called “pass-through” of the exchange rate to inflation has indeed tended to be relatively weak in recent years.
Yet the past may not be a good guide to the present. One of the main reasons why exchange rate depreciations have not proven to be inflationary in recent years is simply that global inflation was stubbornly low. This is no longer true. It is worth worrying that at a time when inflation is accelerating, a currency depreciation is more likely to add a boost to domestic price pressures. Add combustible materials to a fire and you get more fire.
The global economy is quite a hostile environment for developing countries these days: increasing risks of recession in the West; an uncomfortable slowdown in China; reduced availability and higher cost of funding as investors become more risk averse; acceleration of inflation almost everywhere; and growing concern about food availability in a number of countries.
And that’s right in the foreground. Against the backdrop, the prospect of de-globalization efforts by policymakers in the United States, Europe, and China to achieve supply chain resilience will come at the expense of future foreign direct investment flows to economies. emerging.
With all this, a rising dollar is the last thing developing countries need. Still, the problem might not go away any time soon. In the early 1980s – the last time the United States faced a truly stubborn inflation problem – the dollar rose nearly 80%. History may not quite repeat itself, but if the dollar continues to strengthen with the same ferocity as it did 40 years ago, it will be a bumpy ride for emerging economies.