By Frances Coppola
Start with the U.S. Federal Reserve, on which it seems like all eyes have been trained since it paused interest rate rises. Many economists now expect the Fed to partially reverse the interest rate rises of 2018, with Bloomberg reporting that markets are pricing in at least two interest rate cuts in 2019.1
Normally, Fed cuts mean a weaker dollar, but the dollar remains strong, at least partly due to the weakness of other currencies. The euro, for example, fell versus the dollar when the European Central Bank President, Mario Draghi, mentioned cutting rates and re-starting quantitative easing (QE) in response to persistently low inflation and weakening growth.2 Likewise sterling, which is increasingly affected by political uncertainty,3 and the Chinese yuan, which China is reportedly allowing to depreciate to support the Chinese economy.4
As dark clouds gather over these major economies and global trade shrinks to its lowest for a decade, both the International Monetary Fund (IMF) and the World Bank have cut their outlook for global growth.5
Weaker growth coupled with a persistently strong dollar exchange rate tends to increase exchange rate volatility, especially in developing countries. This could raise exchange rate risk for U.S. companies trading with those countries—and make life more difficult for U.S. domestic businesses too.
Research shows that a strong dollar exchange rate makes it more difficult for businesses in developing countries to obtain U.S. dollars to pay suppliers, raising the risk of corporate defaults and bankruptcies along supply chains. A strong dollar exchange rate can also risk making it more difficult for developing countries to pay for essential imports and service dollar-denominated debts, which raises the risk of exchange rate collapse and debt default.
Many developing countries have built up substantial FX buffers to insulate them from the possibility of exchange rate volatility compromising their ability to meet external obligations. But FX buffers are not always adequate: for example, in 2018, Argentina was forced to seek assistance from the IMF when the peso’s collapsing exchange rate made servicing the country’s large dollar-denominated debt impossible. Analysts specializing in emerging markets say that exchange rate volatility tends to be higher in countries with high dollar-denominated debt and low FX reserves, especially if they also suffer from political uncertainty.6
The dollar’s growing dominance of international trade and FX markets since the 2008 financial crisis also tends to increase developing country exchange rate volatility. Over 50 percent of trade is now invoiced in U.S. dollars,7 and over 80 percent of currency transactions involve dollars.8 Consequently, developing countries are significantly more sensitive to dollar exchange rate movements than they were in the past. Bank of England (BoE) research suggests that the influence of U.S. financial conditions on foreign GDP has increased by a third relative to its average from 1990 to 2005.9
Mark Carney, the Governor of the BoE, warned in a June 2019 speech that dollar dominance and the growing importance of market-based finance—when investment funds buy a developing country’s government and corporate debt—mean developing countries may find it increasingly difficult to protect themselves against “sudden stops.”10 A sudden stop is when government and businesses in a country suddenly find credit facilities terminated and access to capital markets denied, excluding them from global finances.
Since the financial crisis of 2008, banks have reduced their lending to developing countries, but this has been replaced by inflows from investment funds. Investment fund flows to emerging markets now account for around one-third of total portfolio flows, compared to around one-tenth pre-crisis, Carney said. He explained that since many of these funds let customers withdraw funds on demand, as banks do, they are particularly likely to pull funds from riskier investments such as developing country debt without warning. Thus, developing countries’ growing reliance on inflows from investment funds raises the risk of the feared sudden stop.
Carney further said the BoE estimates that “the growing shares of FX-denominated debt, market-based intermediation and, within that, the increasing role of investment funds” may have increased the risk of sudden capital reversal by as much as 50 percent since the financial crisis. This largely uses up the self-insurance purchased by emerging market governments through FX reserve accumulation, leaving them increasingly vulnerable to sudden stops. He calls for increased funding for the IMF and wider use of precautionary IMF support to help developing countries defend their currencies and economies from volatile capital flows.
It’s not just developing countries that are at risk when capital flows become unstable and exchange rate risk increases. Carney says that rising capital flow instability could reduce global GDP by as much as 1.2 percent. Because of the growing dominance of the dollar, this increasingly “spills back” to the U.S. According to Carney, the spillback from a 1 percent fall in GDP in developing countries now decreases U.S. output by 0.15 percent, compared to 0.1 percent in 1990.
Fed monetary policy tightening can thus “spill back” to the U.S. via the adverse impact on developing countries, considerably amplifying its intended effect. Carney estimates that spillbacks from a tightening in U.S. financial conditions have tripled, and now account for around 6 percent of the impact of changes in U.S. financial conditions on U.S. GDP.
For U.S. businesses, weakening global growth and the persistently strong dollar could result in the economic environment both abroad and at home becoming more difficult, with rising supply chain and exchange rate risks.
With 17 years' experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Markets Are Screaming Rate Cuts, It’s Fed’s Turn To Respond,” Bloomberg; https://www.bloomberg.com/news/articles/2019-06-03/treasuries-are-on-biggest-rally-since-2008-as-fed-rate-cut-seen
2. “Draghi sees prospect of more ECB stimulus amid weak inflation,” Bloomberg; https://www.bloomberg.com/news/articles/2019-06-18/draghi-says-further-interest-rate-cuts-remain-part-of-ecb-tools-jx1j9wch
3. “Pound Sterling In Fresh Leg Lower Vs. Euro, Dollar; Hammond Resignation Threats Cited,” Pound Sterling; Live https://www.poundsterlinglive.com/gbp-live-today/11536-pound-to-euro-and-dollar-hammond-resignation-threats
4. “China’s yuan dropping below 7 to the U.S. dollar is no longer ‘forbidden zone’, analysts say,” South China Morning Post; https://www.scmp.com/economy/china-economy/article/3013037/chinas-yuan-dropping-below-7-us-dollar-no-longer-forbidden
5. “World Bank Cuts Global Outlook As Trade Tumbles To Decade Low,” Bloomberg; https://www.bloomberg.com/news/articles/2019-06-04/world-bank-cuts-global-outlook-as-trade-tumbles-to-decade-low
6. “EM currency falls bring big opportunities for investors,” Financial Times; https://www.ft.com/content/ec9570aa-71b0-11e9-bf5c-6eeb837566c5
7. “The international price system,” Gopinath, National Bureau of Economic Statistics; https://www.nber.org/papers/w21646.pdf
8. “Triennial Central Bank Survey,” Bank for International Settlements; https://www.bis.org/publ/rpfx16fx.pdf
9. “Pull, Push, Pipes: Sustainable Capital Flows for a New World Order,” Bank of England; https://www.bankofengland.co.uk/-/media/boe/files/speech/2019/pull-push-pipes-sustainable-capital-flows-for-a-new-world-order-speech-by-mark-carney.pdf