THE world’s most important currency is flexing its muscles. In the three weeks following Donald Trump’s victory in America’s presidential election, the dollar had one of its sharpest rises ever against a basket of rich-country peers. It is now 40% above its lows in 2011.
It has strengthened relative to emerging-market currencies too. The yuan has fallen to its lowest level against the dollar since 2008, and anxious Chinese officials are said to be pondering tighter restrictions on foreign takeovers by domestic firms to stem the downward pressure. India, which has troubles of its own making, has seen its currency reach an all-time low against the greenback. Other Asian currencies have plunged to depths not seen since the financial crisis of 1997-1998.
The dollar gradually had been gaining strength for years. The prompt for this latest surge, however, is the prospect of a shift in the economic-policy mix in America. The weight of investors’ money has bet that Trump will cut taxes and spend more public funds on fixing America’s crumbling infrastructure. A big fiscal boost would lead the Federal Reserve to raise interest rates at a faster rate to check inflation. America’s 10-year bond yield has risen to 2.3%, from almost 1.7% on election night. Higher yields are a magnet for capital flows.
Although America’s economy makes up a smaller share of the world economy, global financial and credit markets have exploded in size. The greenback has become more pivotal. That makes a stronger dollar more dangerous for the world and for America.
America’s relative clout as a trading power has been in steady decline: The number of countries for which it is the biggest export market dropped from 44 in 1994 to 32 two decades later. The dollar’s supremacy as a means of exchange and a store of value remains unchallenged, however. Some aspects of the greenback’s power are clear to see. By one estimate in 2014 a de-facto dollar zone, comprising America and countries whose currencies move in line with the greenback, encompassed perhaps 60% of the world’s population and 60% of its G.D.P.
Other elements are less visible. The amount of dollar financing that takes place beyond America’s shores has surged in recent years. As emerging markets grow richer and hungrier for finance, so grows their demand for dollars. Since the financial crisis low interest rates in America have led pension funds to look for decent yields elsewhere. They have rushed to buy dollar-denominated bonds issued in unlikely places, such as Mozambique and Zambia, as well as those issued by large emerging-market companies. These issuers were all too happy to borrow in dollars at lower rates than prevailed at home. By last year this kind of dollar debt amounted to almost $10 trillion, a third of it in emerging markets, according to the Bank for International Settlements, a forum for central bankers. When the dollar rises, so does the cost of servicing those debts.
The pain caused by a stronger greenback stretches well beyond its direct effect on dollar borrowers, however. That is because in many cases cheap offshore borrowing has caused an increased supply of local credit. Capital inflows push up local asset prices, encouraging further borrowing. Not every dollar borrowed by emerging-market companies has been used to invest. Some of the money ended up in bank accounts, where it can be lent out again, or financed other companies.
A strengthening dollar sends this cycle into reverse. As the greenback rises, borrowers hoard cash to service the increasing cost of their own debts. As capital flows out, asset prices fall. The upshot is that credit conditions in lots of places outside America are bound ever more tightly to the fortunes of the dollar. It is no coincidence that some of the biggest losers against the dollar recently have been currencies in countries, such as Brazil, Chile and Turkey, with lots of dollar debts.
There are lurking dangers in a stronger dollar for America too. The trade deficit will widen as a strong currency squeezes exports and sucks in imports. In the Reagan era a soaring deficit stoked protectionism. This time America starts with a big deficit and one that has already been politicized, not least by Trump, who sees it as evidence that the rules of international commerce are rigged in other countries’ favor.
A bigger deficit raises the chances that he will act on his threats to impose steep tariffs on imports from Mexico and China in an attempt to bring trade into balance. If Trump succumbs to his protectionist instincts, the consequences will be disastrous for all.
© 2016 Economist Newspaper Ltd., London (December 3). All rights reserved. Reprinted with permission.
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