The US dollar hasn’t been stronger since 2000 – it has appreciated:
22% – Yen,
13% – Euro,
6% – emerging market economies.
The dominance of the US$ has serious implications for the macroeconomy of almost all countries. Although US share of world trade has declined from 12% to 8% the US$ share of world exports has remained around 40%. Therefore imports denominated in US$ into countries have become more expensive and it is estimated that for every 10% US$ appreciation adds 1% to the country’s inflation figure. For developing countries with a high dependency on US$ denominated imports this is particularly worrisome. Furthermore almost 50% of cross-border loans and international debt securities are in US$ and although emerging market governments have made progress in issuing debt in their own currency, their private corporate sectors have high levels of dollar-denominated debt. As the US Fed continue to raise interest rates with a fourth consecutive 75 basis points rise on 2nd November financial conditions have tightened and the strong US$ only compounds these pressures especially for many low income countries that are close to defaulting on their debt.
What should countries do? Some countries and intervening in the foreign exchange buying their own currency with US$ reserves – foreign reserves fell by over 6% in the first half of this year to support their currency. Intervention should not be a permanent policy as it could mean a loss of foreign reserves as well as alerting markets to your intentions which could play into the hand of foreign exchange dealers. Monetary policy needs to keep inflation close to its target rate and the higher price of imports should reduce demand and therefore prices but a lot depends on the elasticity of demand for a country’s imports – if inelastic there is increasing pressure on inflation. Fiscal policy should provide some support to those that are most vulnerable without jeopardising the inflation target.
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With the impact of technology and the geopolitical changes happening in the global economy is the US dollar coming under pressure as the world’s reserve currency? The data indicates that the US dollar still reigns with approximately 60% of the world’s central banks’ foreign exchange reserves invested in US dollar-denominated assets. Most commodity contracts, like oil, are priced and settled in dollars. It is used as the medium of exchange for the majority of global transactions – see chart below:
The US economy now accounts for about 25% of global GDP (at market exchange rates), down from 30% in 2000 and changes are happening in foreign exchange markets. One area that has impacted this is that transactions between emerging market currencies are becoming easier. China and India, for example, will soon no longer need to exchange their respective currencies for dollars to conduct trade cheaply.
What about the Chinese renminbi? Although there has been some progress with the renminbi as it now accounts for approximately 3% of international payment transactions, and 3% of global foreign exchange reserves are held in renminbi. However it is unlikely to challenge the dominance of the dollar unless there are market driven reforms and upgrades to its institutional framework.
US dollar debt Foreign investors, including central banks, hold nearly $8 trillion in US government debt. Overall US financial obligations to the rest of the world total $53 trillion. Because these liabilities are denominated in dollars, a plunge in the value of the dollar would make no difference to the amount the United States owes but would reduce the value of those assets in terms of the currencies of the countries that own them. China’s holdings of US government bonds, for instance, would be worth less in renminbi.
Source: Enduring Preeminence by Eswar Prasad. IMF Finance & Development. June 2000
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There has been a lot of talk about global currency’s depreciating against the US dollar but why has the dollar been so strong? In times of uncertainty people gravitate to the US dollar for safety – it is the global reserve currency and the vast majority of global trade is done in US dollars. The uncertainty in the global economy has been due to:
Expansionary fiscal and monetary policy
Supply side problems not being able to keep up with demand
Ukraine War which has increased energy and food prices.
From the above there has been strong inflationary pressure in the US especially and this needs contractionary monetary policy intervention – higher interest rates. The US Fed Reserve has increased interest rates ahead of other developed economies.
Problems with a strong US dollar When the US dollar appreciated – see image above – it has a contractionary impact on the global economy. The dollar and US capital markets are far more globally important than the US economy itself – the currency is the world’s safe haven and its capital markets are those of the world. Therefore the exchange rate is crucial when money goes into and out of the US. Also countries worry about the exchange rate in particular when inflation is high – weak currency makes imports more expensive and can feed inflation. For those that owe money in US dollars a weak currency becomes very expensive as they have to convert more of their currency into US dollars – this is prevalent in the developing world. With Fed Chair Jerome Powell determined to bring US inflation down there is the risk of further interest rate hikes which could put economies into recession.
Source: Financial Times – Why does the strength of the US dollar matter? Martin Wolf
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The recent tightening of monetary policy by US Fed Chair Jerome Powell to combat inflation has seen higher borrowing costs and financial-market volatility. The US$ has risen 7% against a series of major currencies since January this year – a two year high. It has always been a safe haven currency and with a rising Fed Rate and market rates even more capital could flow into the US increasing the demand for US dollars and therefore appreciating its value. See mindmap below for the theory behind a stronger currency.
A high value of a currency makes exports more expensive but does lead to cheaper imports especially of the inelastic nature. But to foreign economies it does drive up import prices further fueling inflation. For developing countries this is a concern as they are being forced to either allow their currencies to weaken or raise interest rates to try and stem the fall in value. Also developing economies are concerned with the risk of a ‘currency mismatch’ which happens when governments have borrowed in US dollars and lent it out in their local currency. However it is not just developing countries that have had currency issues. This last week saw the euro hit a new five-year low with the US Fed’s aggressive tightening of monetary policy. The real problem for some economies is that they are further down the business cycle than the US so in a weaker position.
“While domestic ‘overheating’ is mostly a US phenomenon, weaker exchange rates add to imported price pressures, keeping inflation significantly above central banks’ 2% targets. Monetary tightening might alleviate this problem, but at the cost of further domestic economic pain.” Dario Perkins – chief European economist at TS Lombard in London
Source: Bloomberg – Dollar’s Strength Pushes World Economy Deeper Into Slowdown. 15th May 2022
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In doing most introductory courses in economics you will have come across the four functions of money which are:
Medium of exchange
Unit of Account
Store of Value
Means of deferred payment
Since the Bretton Woods Agreement in 1944 the US dollar was nominated as the world’s reserve currency and ranks highly compared to other currencies in the above functions. As a medium of exchange the US dollar is very prevalent:
60% of the world’s currency reserves are in US dollars
50% of cross-border interbank claims
After the GFC, purchases of the US dollar increased significantly – store of value.
Around 90% of forex trading involves the US dollar
Approximately 40% of the world’s debt is issued in dollars
n 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.
So why therefore is there pressure on the US dollar as the reserve currency?
The COVID-19 pandemic has closed borders and will inevitably lead to more regionalised trade, migration and money flows which suggests a greater use of local currencies. However China has made its intention clear that the Yuan should become a more universal currency. Some interesting facts:
Deposits in yuan = 1trn yuan = US$144bn
Yuan transactions have grown in Taiwan, Singapore, Hong Kong and London.
Investment by Chinese firms into Belt and Road project = US$3.75bn which was in yuan
China settles 15% of its foreign trade in yuan
France settles 20% of its trade with China in yuan
The IMF suggest that the ‘yuan bloc’ accounts for 30% of Global GDP – the US$ = 40%
However if the past is anything to go by the US economy has gone through some very turbulent times but the US dollar has remained firm. This suggests that how we perceive the US economy doesn’t seem to relate to the value of its currency.
Source: The Economist – China wants to make the yuan a central-bank favourite 7th May 2020
The Washington Post recently reported that with the prospect of the Fed maintaining lower interest rates than its counterparts elsewhere, the US dollar is losing its status as the world’s safe currency in troubled times. The dollar is still dominant but when the European economy gets its fiscal issues resolved – could take a long time – that might lead to a shift away from the dollar to the euro. However on a positive side for the decline in the US$ is that it has been more systematic and not driven by foreign exchange speculators getting out of dollars but by sentiment that the euro, the GB pound, the Canadian dollar are a better buy at this stage. This is ironic as the US economy is starting to pick-up pace, albeit slowly, and the debt crisis in Europe seems to be getting worse – Portugal look as if they will need to be bailed out.
Remember that high interest rates attract foreign investment into a country which means that investors have to change their currency, in the foreign exchange market, into the currency of that country that they wish to invest in. Therefore the demand for that currency goes up which means that it will increase in value. Ben Bernanke has consistently said that he wants to keep short-term interest rates near to zero for an extended period – whatever that means.
From the Wall Street Journal – the state-controlled Bank of China Ltd. is allowing customers to trade the yuan, also known as the renminbi, in the U.S. The decision is the latest move by China to allow the yuan, whose value is still tightly controlled by the government, to become an international currency that can be used for trade and investment.
“We’re preparing for the day when renminbi becomes fully convertible,” Li Xiaojing, general manager of Bank of China’s New York branch, told The Wall Street Journal. He said the bank’s goal is to become “the renminbi clearing center in America.”
Bank of China’s move comes at a time of U.S. pressure on China to let its currency rise in value. America has blamed an unfairly valued yuan for exacerbating the U.S. trade deficit with China. But the preparations for convertibility are also a sign of Chinese strength, as China, now the world’s second-largest national economy, recognizes that as a global power it must have a global currency. In time, a globally traded yuan could emerge as a store of value on par with the dollar, euro and yen.