As if the energy crisis and the highest inflation rates in four decades were not disruptive enough, the global economy is also being rattled by big realignments in exchange rates. After two decades of being stronger than the dollar, the euro is now at parity with the greenback. Last week, sterling fell to its lowest level against the dollar since 1985 — and many analysts expect it to fall further. The yen, meanwhile, has continued its precipitous slide against the dollar, and is set for its worst year on record.
One part of this story follows a familiar pattern: in times of trouble, currency traders and investors flock to the dollar as a safe haven. That was true even in the 2008 global financial crisis, when the US’s own financial collapse was the epicentre. Right now a multitude of factors are driving demand for the security of US assets: the war in Ukraine, Europe’s energy crisis, and precariousness over how some emerging markets will manage high oil and food prices. The US is essentially the least unsafe option, particularly given its position as a net energy exporter.
Economic fundamentals also back up the run to the dollar. At this year’s Jackson Hole confab, US Federal Reserve chair Jay Powell’s speech was short but crystal clear in its message: the Fed will not hesitate to push up interest rates even further in its quest to bring down inflation, which is still running at more than four times its target. This raises the relative draw of dollar securities, with central bank policy rates lagging behind in other advanced economies. The outlook for the eurozone and Chinese economies have also darkened, while recent data point to some resilience in the US, alongside President Joe Biden’s fiscal support.
A number of idiosyncratic factors have also contributed to some currencies’ weaknesses. Russian president Vladimir Putin’s weaponisation of gas flows means the European economy is undergoing a huge terms-of-trade shock. Uncertainty over how it will overcome the energy crisis has made investors jittery. In Britain, confidence in fiscal credibility has been dented by the new government’s already strained public finances, swipes at independent economic institutions and enormous borrowing plans. The Bank of Japan has meanwhile persisted with considerably loose monetary policy, to stimulate growth and inflation.
The strength of the dollar, in turn, has profound implications. In advanced economies, central banks are playing catch-up with the Fed to avert a further weakening of their currencies — which also raises imported inflation. Rising rates are all the more problematic for some as energy crisis borrowing adds to already high pandemic debt piles. In emerging countries it threatens balance of payment crises by raising dollar-denominated debt burdens and driving disruptive capital outflows. About 20 emerging markets have debt that is trading at distressed levels, according to the IMF.
There are no quick solutions. The only sustainable way for advanced economies to regain ground on the dollar is via credible and prudent policies that will usher them through today’s crisis and on to higher growth paths. For the emerging world, better co-ordinated multilateral debt restructuring is key.
America’s shrinking share of global output, the rise of digital currencies and the weaponisation of the dollar in sanctions against Russia have all been cited as reasons for its potential demise. Yet the currency still has an outsized influence on the global economy given its dominant role in global trade and finance. In 1971, then US Treasury secretary John Connally warned his international counterparts that the dollar was “our currency but your problem”. More than 50 years on, his words remain true.