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Making Cents Out of Dollar Strength: The Effect on Emerging Markets

In the aftermath of the financial crisis, the US largely benefited from having a strong dollar on its path to recovery. Ten years later, however, the same currency’s value is so distorted that it may well be enough to strangle its economy.

Apr 7, 2017 // 1:41PM

After the 2007-2008 financial crisis, the US benefitted from having a strong currency, with the failure of the country’s biggest financial institutions creating a need for fresh liquidity from abroad.

According to Jan Dehn, the Head of Research for Ashmore investment, the strong US dollar had a positive effect on the capital account by inducing foreigners to put money into the US, “especially if the dollar starts from cheap levels and there is upside in stock markets. This has been the case since 2010.”

However, almost ten years later, the superpower’s prospects are looking somewhat mixed; over the past few years, the US has experienced mediocre growth and rising inflation, while at the same time maintaining massive inflows of money from abroad. This has contributed to a misalignment of the value of the US dollar, Dehn argues, with its true value totally out of sync with the country’s fundamentals.

After the surprise victory of Donald Trump in November last year, most analysts forecast an extended US dollar rally. Curiously enough, and despite an upward interest rate trajectory, the currency has been edging downward as of late. The dollar index is down about 2.1% since the start of the year, and 1.4% since the Federal Reserve met in March.

Despite the unexpected drop, is the dollar still too high? Dehn believes so. “The US dollar is extremely overvalued. US growth is weak, and the US real exchange rate is strangling the US economy. The US had benefitted from a strong dollar a few years ago, when it needed financing from abroad and the when the dollar was trading a very cheap valuation. But now, however, the dollar is expensive, the US no longer needs the foreign financing and hence would be better served with a lower dollar so that the export sector can lead growth,” he argued.

 “As the dollar rises eventually the drag on exports becomes more important than the benefit of cheap financing. I would argue that the dollar is now so strong that the net effect is negative”.

Why a Weaker Dollar Could Help Emerging Markets

Emerging markets are likely to benefit from a weaker dollar in two ways.

First, the weaker dollar would make US exports more competitive and therefore eat into EM’s global export share. This would take a long time to play out, but it is important to highlight nevertheless.

Second, capital would flow out of the US markets and back to EMs. This would weaken US financial asset prices and stimulate both asset prices and investment and consumption in EM. This would be slightly more immediate.

There are nuances here. In Latin American, the US dollar plays a unique role, not only for the region’s business relationship with the US, but also because of the relatively high concentration of dollarized economies (countries that use the US dollar as a functional currency) or currencies that are pegged to the dollar.

Countries like Panama, Ecuador, and El Salvador are all heavily exposed to US dollar volatility in different ways; for instance, Panama is a service driven economy, so US dollar volatility has a less dramatic influence on the domestic economy than it does in El Salvador, which has deep agricultural and manufacturing sectors.

Still, much of the region relies on commodity exports.

“At the margin, such countries would lose financing from local currency markets, though to the extent that they are commodity producers they will likely have some offsetting benefits from the lower dollar. After all, commodities are traded in USD, so a weaker dollar would increase commodity prices”.

At a time when protectionism seems to be gaining traction globally, Emerging Markets must now also prepare to guard themselves against the challenges of a misaligned dollar. ‘Stronger’ is not always ‘better’.

Americas Currencies Policy & Government Global

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