How A Strong Dollar Hurts Europe + Emerging Markets

Is a strong dollar all good? Depends where you sit in the global economy.

For sure the greenback is almighty these days. the dollar index, which measures the strength of the currency relative to other major currencies, is at its highest level since April 20o2, or more than two decades.

That shouldn’t be too surprising as higher interest rates tend to attract capital from overseas. In America’s case, the Federal Reserve acted more aggressively to fight inflation than any other central bank. It’s done so by raising the cost of short-term borrowing to 3.25% recently, up from less than 1% earlier this year. The result was the dollar became king of currencies.

A strong dollar is certainly a plus for the U.S. as Forbes contributor John Tobey outlines here.

However, if you aren’t in the U.S. a strong dollar could be bad, really bad or excruciating bad. It’s different depending where you live.

Europe’s Dollar Problem

Let’s look at Europe. Europe’s inflationary surge is quite unlike the U.S. problem. The U.S. jump in the cost of living is in large part due to the massive fiscal stimulus during the COVID-19 pandemic.

Europe’s is due more to the energy supply shock following Russia’s invasion of Ukraine.

The higher dollar puts the European Central Bank, which manages the euro currency, and the Bank of England, which looks after the British pound.

Both banks are caught in a sticky situation. They both know that domestic European inflation will not be helped by raising interest rates. That’s because no matter how high the cost of borrowing goes, it won’t supply more energy to Europe.

But at the same time, the central bankers know that if they don’t raise interest rates roughly in line with what the Fed does, then the value of their currencies will drop. In both cases this is what the banks decided to do.

The euro now fetches a little less than a dollar, down from around $1.17 a year ago. Likewise, a year around a pound would fetch $1.39, versus 1.16 recently.

And there’s the rub. Countries with a falling currency tend to import inflation. That’s because the cost of most things in the world is denominated in U.S. dollars.

Putting it simply, Europe’s central banks had to decide between crushing their rather weak economies with higher interest rates or importing inflation, which would cripple their economies more slowly. So far they have chosen the latter, and the result will be bad, but likely not really bad or excruciatingly bad.

Emerging Markets

Emerging markets are those economies that are growing but have not reached the level of the developed world such as Western Europe, the U.S., Canada and Japan.

Unlike western governments, some EM economies borrowing U.S. dollars rather than sell bonds denominated in their home currency.

For instance, Indonesia has dollar denominated loans worth more than 7% of GDP as of 2020.

That means that the steady decline in the value of the Rupia, the Indonesian currency, this year will have made that debt an even larger problem for the Indonesian government. The finance minister will need to either buy increasingly expensive dollars on the market to pay the interest on the debt, or run down the country’s reserves of dollars. It choose the latter with foreign exchange reserves dropping steadily this year.

Other countries are similarly exposed. The good news for Indonesia is that it exports commodities, which as a whole have done well this year. Its economy is growing quite well.

However, if the dollar keeps surging, the Indonesia and similar EM countries with dollar-denominated debt could find themselves in financial difficultly. Certainly, this would be really bad compared to the problems faced by Europe. However, its not excruciatingly bad.

Frontier Markets

Frontier markets are those economies that are fragile. An example of that is Pakistan, which for a while had EM status, but partly thanks to the COVID-19 pandemic slipped back again.

When the U.S. and Europe mandated an economic shut down in late March 2020, capital fled to the safety of U.S. Treasurys. While the dollar soared the Pakistan rupee fell to a then record low versus the dollar.

Despite an optimistic outlook for Pakistan pre pandemic, as the crisis developed investors began pulling their money out of the country. What followed was continued decline in the rupee and an increasingly struggling economy.

The country had EM status during the health crisis but quickly got relegated to frontier status. The recent continued surge in dollar seems to have made matters worse.

Pakistan’s GDP per capita is expected to drop to $1,250 by the end of 2022 down from around $1,500 in 2019, according to TradingEconomics. Of course, that’s not going to help anyone in that country.