by Joseph Joyce
The foreign currency value of the dollar has been rising. The nominal broad dollar index of the Federal Reserve shows the dollar has increased by about 9% since its low point a year ago while other indexes register larger gains. What does this mean for the U.S. and other economies?
The appreciation reflects several factors. First, higher interest rates make investing in dollar-denominated assets more appealing, particularly since many other major central banks lag the Federal Reserve’s in its monetary tightening. The European Central Bank will not begin to raise its rates until July, while the Bank of Japan has no plans to change its accommodative policy stance. Second, the dollar’s “safe asset” status draws investors who fear the economic and political uncertainty due to the Russian invasion of Ukraine. Third, the COVID19 lockdowns in China have disrupted its economy, while the U.S. has not (yet) exhibited any significant slowdown.
A rising dollar will contribute to the increasing U.S. trade deficit. American consumers may be losing confidence because of inflation, but they are still purchasing foreign goods. Lower import prices will assist the Fed in combatting inflation, which could slow future hikes in interest rates..
The dollar’s appreciation will also have an impact on the foreign-based revenues and profits of U.S. based multinationals. A 2018 S&P 500 research paper by Philip Brzenk showed that changes in the value of the dollar had an impact on S&P 500 companies with significant foreign activities. An appreciation (depreciation) of the dollar lowers (raises) the value of the foreign earnings of those companies with major foreign currency exposure, which is accompanied by decreases (increases) in the values of their share prices relative to those firms in the S&P 500 with little foreign exposure. A decline in foreign-sourced income will also affect the net income balance of the U.S. balance of payments, contributing to a further weakening of the current account.
The impact on foreign economies of the rising dollar is also mixed. On the one hand, those countries that export to the U.S. should benefit from lower prices for their goods. However, this effect is mitigated when their export prices are denominated in dollars. Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gopinath, Helena Le Mezo, Arnaud Mehl, and Tra Nguyen of the IMF drew attention to the growing use of the dollar as a vehicle currency and the implications for trade balances in a 2020 IMF working paper, “Patterns in Invoicing Currency in Global Trade.”
Moreover, any expansionary effect due to increased trade can be offset by what has been called the “finance channel.” The financial channel reflects the impact of the exchange rate on the value of foreign currency liabilities, such as loans taken in a foreign currency. An appreciating dollar will raise the domestic value of those liabilities. Jonathan Kearns and Nikhil Patel of the Bank for International Settlements examined these channels in their article, “Does the Financial Channel of Exchange Rates Offset the Trade Channel?”, which appeared in the December 2016 issue of the BIS Quarterly Review. They found evidence that the financial channel partly offsets the trade channel for emerging market economies (EMEs) but that it is weaker for the advanced economies.
Similarly, Boris Hoffman and Taejon Park of the BIS reported that a dollar appreciation contributes to a deterioration of growth prospects of emerging market economies in their 2020 BIS Quarterly Review paper, “The Broad Dollar Exchange Rate as an EME Risk Factor.” They found that a dollar appreciation dampens investment growth and even export growth. These effects were larger in countries with high dollar debt and high foreign investor presence in local currency bond markets, which contribute to the financial channel.
Another examination of the impact of changes in the value of the dollar on emerging market economies was undertaken by Pablo Druck, Nicolas E. Magud and Rodrigo Mariscal of the IMF in “Collateral Damage: Dollar Strength and Emerging Markets’ Growth,” which appeared in the North American Journal of Economics and Finance in 2018 (IMF working paper version here). They found evidence of a negative relationship between the strength of the dollar and emerging markets’ growth. They attributed this empirical relationship to two channels of transmission: first, a negative linkage with commodity prices that depresses demand for the exports of commodity producers; second, an increase in the cost of imported capital imports that are necessary for growth. While supply shocks will keep commodity prices elevated, the price of capital imports has already risen due to widespread inflation.
The impact of the appreciation of the dollar will spread far outside U.S. borders. These effects will occur in countries already grappling with higher food and energy costs, and the consequences of a slowing Chinese economy. A global recession is not inevitable, but the IMF’s Managing Director Kristalina Georgieva is not exaggerating when she says that the world economy faces “its biggest test since the second world war.”