Is the strong Dollar becoming a drag?
Tom Traill - 16 October 2019
The strength of the US Dollar weighs heavily on many investors’ minds. The trade-weighted Dollar index has appreciated for seven years, shaking off the weakness in 2017. Despite many factors that suggest there should be weakness ahead – excess government borrowing, implying an abundant supply of Dollars, the fragility of US corporate credit and the rich international valuation of the US equity market – there are few signs that this trend is ready to break.
For investors in emerging markets a strong dollar is a perennial headache. Commodities are generally priced in Dollars, making raw materials more expensive, as is also true for some services. Debt is often priced in Dollars and therefore interest is more expensive. The one redeeming factor for EM firms in a strong Dollar environment is supposed to be an improvement in competitiveness that makes their exports relatively cheaper.
However, research from the BIS this week piles on the pain for EM exporters. Their working paper suggests that “a broad appreciation of the US Dollar dampens international trade by weighing on the operation of credit-intensive global value chains” and “a detailed empirical analysis using 4.6 million observations of export shipments by product category shows that when Dollar credit conditions tighten, firms that rely more on wholesale dollar-funded banks suffer a greater contraction in exports. This is due to greater stringency in access to working capital to sustain global value chains.”
So, “the Dollar exchange rate affects real outcomes not only through competitiveness, but also through fluctuations in credit supply.” This negative effect on EMs, particularly those with long supply chains, has been compounded by the trade war and the drift towards autarky that we have seen in recent years.
Meanwhile, the IMF this week has released a paper suggesting that post-crisis regulations have not sewn up all the holes in the financial fabric, and shows “that an increase in US Dollar funding costs leads to financial stress in the economies that are home to global non-US banks and to spillovers through a cutback in loans to recipient economies, those that borrow US dollars.”
The benefits of the strong Dollar for the US – cheaper imports primarily - are beginning to diminish thanks to reasons detailed above, while US exports suffer. The Bank of England governor, Mark Carney, among others, has highlighted that the Federal Reserve and the US Dollar are beginning to paint themselves into a corner. The strength and reach of the Dollar mean that the Fed can not react as they might wish since the secondary costs potentially outweigh the primary benefits. Whichever way they turn, they face a potential problem; their choice seems to be whether it is either internal or external in origin.
While investors regard US Dollar assets as a place of refuge, then it is likely that emerging markets will continue to struggle. However, as the perception grows, not least in the White House, that the strength of the US Dollar is a lose-lose proposition, then an inflection point may be close at hand. The US Treasury and the Federal Reserve can relax the terms of access of foreign banks to US Dollar borrowing, if they so wish. How painful does the strong Dollar need to be?
Figure 1: Exports and US Dollar credit
NB The left panel shows the ratio of world merchandise exports to world output (right axis) and a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners, based only on trade in goods (left axis). Data are normalized as of Q1 2000. The right panel shows the annual growth of credit to non-banks denominated in US dollars and the annual growth of the Federal Reserve Board trade-weighted nominal dollar index, major EMEs.
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