Currency fluctuations aggravate global economic difficulties
As if the energy crisis and the highest inflation rates in four decades weren’t disruptive enough, the global economy is also rocked by major exchange rate realignments. After being stronger than the dollar for two decades, the euro is now at par with the greenback. Last week, the pound fell to its lowest level against the dollar since 1985 – and many analysts expect it to continue to fall. The yen, meanwhile, continued its steep fall against the dollar and is about to experience its worst year on record.
Part of this story follows a familiar pattern: in times of trouble, forex traders and investors flock to the dollar as a safe haven. This was true even during the global financial crisis of 2008, when the financial collapse of the United States was its epicenter. Right now, a host of factors are driving demand for U.S. asset security: the war in Ukraine, the energy crisis in Europe, and the uncertainty of how some emerging markets will handle high oil and food prices. . The United States is essentially the least dangerous option, especially given its position as a net exporter of energy.
Economic fundamentals also support the race for the dollar. At this year’s Jackson Hole conference, US Federal Reserve Chairman Jay Powell’s speech was short but crystal clear in his message: The Fed won’t shy away from raising rates. further in its quest to bring down inflation, which is still running at more than four times its target. This increases the relative attractiveness of dollar-denominated securities, with central bank policy rates lagging in other advanced economies. The outlook for the eurozone and Chinese economies has also darkened, while recent data points to some resilience in the United States, alongside President Joe Biden’s fiscal support.
A number of idiosyncratic factors also contributed to the weaknesses in some currencies. The weaponization of gas flows by Russian President Vladimir Putin means that the European economy is suffering a huge terms-of-trade shock. Uncertainty about how it will overcome the energy crisis has made investors nervous. In Britain, confidence in fiscal credibility has been shaken by the new government’s already strained public finances, blows to independent economic institutions and huge borrowing plans. The Bank of Japan, for its part, persisted in a considerably accommodating monetary policy, in order to stimulate growth and inflation.
The strength of the dollar, in turn, has profound implications. In advanced economies, central banks are trying to catch up with the Fed to avoid further weakening of their currencies, which also increases imported inflation. Rising rates are all the more problematic for some as borrowing related to the energy crisis comes on top of already high pandemic debts. In emerging countries, it threatens balance of payments crises by increasing the burden of dollar-denominated debt and causing disruptive capital outflows. About 20 emerging markets have debt that is trading at distressed levels, according to the IMF.
There are no quick fixes. The only sustainable way for advanced economies to regain ground against the dollar is through credible and prudent policies that will see them through the current crisis and into higher growth paths. For the emerging world, a more coordinated restructuring of multilateral debt is essential.
America’s declining share of global output, the rise of digital currencies, and the weaponization of the dollar in sanctions against Russia have all been cited as reasons for its potential demise. Yet, currency still has an outsized influence on the global economy given its dominant role in global trade and finance. In 1971, then US Treasury Secretary John Connally warned his international counterparts that the dollar was “our currency, but your problem”. More than 50 years later, his words still hold true.