By Frances Coppola
The argument for continued USD decline is based on the strength of major U.S. trading partners, which are starting to experience stronger GDP growth and higher inflation.1 The main counter argument is that the Federal Reserve's interest rate rises and gradual shrinking of its balance sheet as it reverses Quantitative Easing (QE) could strengthen the dollar exchange rate.2 Additionally, tax changes in the U.S. could encourage international corporations to bring back some of their offshore dollar reserves to the U.S., making dollars scarcer internationally and thus putting upward pressure on the USD exchange rate.
Whatever the causes, a rising USD exchange rate would likely challenge developing countries.
"A weaker dollar tends to act as an accelerator for emerging markets," notes The Wall Street Journal.3 This is for three principal reasons:
When the dollar is falling, therefore, developing markets can grow fast.
However, when the U.S. dollar exchange rate rises, both investment and trade fall as dollar funding becomes more expensive for businesses and governments. Additionally, for commodity exporters, inflows of dollars shrink as the price of their principal exports falls in dollar terms. For developing countries, therefore, a rising U.S. dollar exchange rate is typically associated with slowing GDP growth and shrinking international trade.6
The tendency of developing country governments to borrow in USD rather than their own currencies is sometimes called "original sin," because it reflects the fact that their own currencies are much less accepted globally.7 Borrowing in USD enables developing countries to pay for essential goods that would otherwise be unaffordable. When the U.S. dollar exchange rate is weak, it can be hard to resist the temptation to borrow more – but doing so increases the risk of a foreign exchange (FX) crisis down the line.8
Corporations in developing countries also suffer from a kind of "original sin." They often need to borrow in USD, because of the dollar's dominance in international trade. A weak dollar exchange rate enables them to obtain an ample supply of dollars for trade finance, but when the exchange rate rises they can suddenly find themselves unable to obtain the dollars they need, forcing them to cut back their trading activities.
If inflation were to spike in the U.S., the Fed might raise interest rates sharply. This could cause a sudden rally in the USD exchange rate, which could trigger an FX crisis in some developing countries.
In an FX crisis, foreign banks and investors can abruptly withdraw dollar funding, rendering corporations and governments unable to refinance dollar-denominated debt – a phenomenon known as a "sudden stop." Commodity exporters can find their dollar inflows shrink significantly as the prices of their principal exports fall in dollar terms.
As dollars become scarcer, government and business finances can become severely strained, forcing severe cutbacks in spending. When corporations and governments cut back spending to maintain debt service, there can be spillover effects to the real economy, as employees forego wages, suppliers go unpaid, and fire sales of goods force prices down. This can cause a deep recession. If the dollar squeeze continues, then eventually corporations, households and even the government may default on their debts.
However, developing countries are not a homogenous group. It's possible for there to be a crisis in one country without others being affected. For example, Venezuela is currently experiencing a severe FX crisis,9 but other countries in the Latin America region are unaffected. Whether or not a U.S. dollar appreciation – or, for that matter, a sharp commodity price fall – causes FX crisis in a developing country really depends on local conditions.10 High dollar-denominated debt, a fixed or managed exchange rate and a fragile political situation can all indicate vulnerability to FX crisis.
Despite analysts' concerns, the sharp USD exchange rate rise in late 2016 didn't trigger FX crises in developing countries.11 It may be that developing countries are becoming more resilient, reducing the risk of FX crisis.12
A sharp rally in the USD exchange rate could trigger FX crises in one or more developing countries, particularly those that have high levels of dollar-denominated debt and/or are commodity exporters. Vulnerability to USD exchange rate movements depends on local conditions in developing countries. Businesses working in developing countries which have large dollar-denominated debts may wish to consider ways of protecting themselves from the effects of a rising USD exchange rate.
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. “Look out below: more dollar weakness to come, says currency expert,” CNBC; https://www.cnbc.com/2018/02/03/look-out-ahead-more-u-s-dollar-weakness-to-come-says-currency-expert.html
2. “Why a stronger dollar could spoil the emerging-market party,” The Wall Street Journal; https://www.wsj.com/articles/why-a-stronger-dollar-could-spoil-the-emerging-market-party-1514477292
5. “How does a strong dollar affect emerging economies?” World Economic Forum; https://www.weforum.org/agenda/2015/08/how-does-a-strong-dollar-affect-emerging-economies/
7. “The Pain of Original Sin,” Eichengreen, Hausmann & Panizza; https://eml.berkeley.edu/~eichengr/research/ospainaug21-03.pdf
8. “Revisiting original sin,” The Economist; https://www.economist.com/blogs/freeexchange/2014/04/emerging-markets
9. “Venezuela in Crisis,” Council on Foreign Relations; https://www.cfr.org/backgrounder/venezuela-crisis
10. “Why is a Strong U.S. Dollar Bad for Emerging Markets?,” Morningstar; http://www.morningstar.co.uk/uk/news/158277/why-is-a-strong-us-dollar-bad-for-emerging-markets.aspx
11. “Trump-powered dollar to be the bogeyman of 2017 for emerging markets,” Marketwatch; https://www.marketwatch.com/story/trump-powered-dollar-to-be-the-bogeyman-of-2017-for-emerging-markets-2016-12-12
12. “Are Emerging Economies Becoming More Resilient?,” St. Louis Federal Reserve; https://www.stlouisfed.org/on-the-economy/2016/june/are-emerging-economies-becoming-more-resilient