American travelers can rejoice that an evening in Rome that once cost $100 now costs around $80, but that’s a more complicated picture for multinational corporations and foreign governments.
The dollar’s gain is already hurting some vulnerable economies.
“It’s been a challenging environment,” said William Jackson, chief emerging markets economist at Capital Economics.
Why the “dollar smile” leads to frowning
The US dollar tends to appreciate when the US economy is very strong or, somewhat counterintuitively, when it is weak and the world is facing a recession.
Either way, investors view the country’s currency as an opportunity to lock in growth or a relatively safe place to store cash while they weather the storm.
The phenomenon is often called the “dollar smile”, because it rises at both extremes.
But the rest of the world has less to smile about. Manik Narain, head of multi-asset strategy for emerging markets at UBS, identified three main reasons why a stronger dollar could hurt countries around the world with smaller economies.
1. It can add tax pressure. Not all countries have the capacity to borrow money in their local currency, as foreign investors may not have confidence in their institutions or their financial markets are less developed. This means that some have no choice but to issue debt denominated in dollars. But if the value of the dollar skyrockets, it makes it more expensive to pay off their debts, emptying government coffers.
It also makes it more expensive for governments or businesses to import food, medicine and fuel.
2. It fuels capital flight. When a country’s currency weakens significantly, wealthy individuals, corporations, and foreign investors begin to withdraw their money, hoping to hide it somewhere safer. This pushes the currency even lower, exacerbating fiscal problems.
“If you’re sitting in Sri Lanka right now and you see the government is under pressure, you want to get your money out,” Narain said.
3. It weighs on growth. If businesses can’t afford the imports they need to run their business, they won’t have as much inventory. This means that they will not be able to sell as much, even if demand remains robust, which weighs on economic output.
When the US economy is doing well, that can cushion some of the blow. Many emerging markets export goods to the world’s largest economy. But when the dollar strengthens because America is on the verge of recession? It’s hard.
“It can inflict more pain on the markets because you don’t have the silver lining of better economic growth in the background,” Narain said.
A contained crisis
The dollar fell 0.6% last week. But he’s not expected to change course significantly anytime soon.
“We expect dollar strength to remain largely intact in the short to medium term,” wrote Scott Wren, senior global markets strategist at the Wells Fargo Investment Institute, in a recent note to clients.
This has investors and policymakers wondering if Sri Lanka is just the first domino to fall. There is also a risk that the turmoil in emerging markets will spread to the entire financial ecosystem, triggering a wide range of ripple effects.
But there are also key differences between the current situation and past crises.
Debt denominated in dollars is less common than before. The biggest players – such as Brazil, Mexico and Indonesia – “have generally not borrowed much in foreign currencies and now hold enough foreign exchange reserves to manage their external debt”, according to Setser.
In addition, commodity prices such as oil and base metals remain high. This helps emerging economies that are big exporters, including many in Latin America, and is a reliable way to ensure dollars keep flowing into government coffers.
Yet much could depend on the fate of the world’s two largest economies: the United States and China. If these growth engines really start to falter, emerging markets could experience a painful investment exit.
“It will be crucial if the United States goes into recession,” said Robin Brooks, chief economist at the Institute of International Finance. “It makes everyone more risk averse.”