The perils of a stronger dollar …

9 December, 2014

The dollar’s star seems to be in the ascendency.  A 314,000 increase in US payrolls for November, combined with some dovish comments from previously hawkish ECB members, has helped the dollar index to rise to 2006 highs.  A move past 90.00 seems on the cards in the short-term, and if the pace of dollar strength is continued then the FX market would need a miracle to slow this dollar-juggernaut before the New Year.  

But a strong dollar is not without its problems as the Bank for International Settlements pointed out in its Quarterly Review that was released over the weekend. The highlights from its latest report include:

  • Opposing moves by the world’s major central banks is fuelling volatility. If this continues then 2015 could be a volatile year for the FX market.
  • A strong dollar could expose emerging markets to financial vulnerabilities, so 2015 could be a rough ride for emerging markets.
  • Countries with large debts denominated in dollars’ are most at risk, and further dollar appreciation could reduce the creditworthiness of many firms and potentially include a tightening of financial conditions.
  • The report also pondered on the durability of the dollar’s performance in official FX reserves. It found that even though the US economy’s power is shrinking in the face of stiff competition from the East, the dollar still accounts for half of the global economy. The dollar zone includes countries that use the buck, currencies that are (or were) pegged to the buck, and countries that earn in dollars – e.g., oil producers.
  • The BIS found that the countries with currencies that move closely to the dollar tend to have high levels of dollar reserves, as the buck is considered a less risky investment or borrowing currency the more closely the domestic currency moves with the dollar. (See figure 1 for more).
  • This may ensure the dollar’s predominance in official FX reserves for some time and could limit the EUR or the Chinese renminbi from overtaking the greenback any time soon.
  • Thus, if the dollar uptrend persists there could be problems for large swathes of the global economy that have borrowed and invested in dollar-based assets.
  • Cross-border credit flows (which include dollar-based loans) increased nearly 3% in Q2 2014 compared to Q2 2015. The BIS report pointed out that Turkey had seen a notable increase in credit flows in Q2, up $7bn, while there were declines in Eastern Europe, most notably, Ukraine, Russia and Hungary.

There are two things that we can take away from this BIS report – firstly, that emerging markets are at risk from a rising dollar, and secondly, the dollar’s dominance as the major global reserve currency is unlikely to go away any time soon.

Looking at the dollar’s performance over the last 6 months, it is up some 10% vs. the G10, and while some emerging market currencies held their own against the dollar for the first half of this year they have come under increasing pressure in recent weeks. In the last month the Ruble, Mexican peso, Malaysian Ringgit, South Korean Won, Brazilian real and South African rand have fallen substantially versus the greenback. This should give us some indication of which currencies could be at risk in 2015 should the dollar continue to appreciate.  As we mention above, the sharp increase in borrowing in Turkey could also put the Lira at risk in the coming months.

Conclusion:

The fundamental and technical pictures remain solid for the US dollar.
The dollar’s position as the king of official FX reserves is unlikely to be toppled any time soon.
This comes with its own set of problems, credit growth in emerging markets has surged this year, and a large portion of this is in foreign currency, most notably dollars. This means some countries will be vulnerable to a rising dollar as it means that debt-repayments are higher, which could trigger an increase in bad loans, making banks and corporates less credit-worthy.
Back in the 1980s when the dollar was also strong this triggered a wave of EM defaults. Although the EM world is in a stronger position today compared to what it was back then, the EM world is still at vulnerable.
Overall, the strong dollar could be here to stay, but the rising buck could leave a trail of volatility and destruction behind it. 2015 could be a wild year for FX.


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