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World Bank explains why the US dollar continues to gain ground while the cedi keeps losing.

The US dollar has gained over 11% since the beginning of the year and has now equaled the value of the Euro for the first time in two decades.

In fact, a disproportionately large number of important currencies have declined in value relative to the dollar, having significant effects on the developing world.

I wanted to highlight some of the main effects that a strong dollar has on emerging markets given the abundance of stories (EMs).

First, why is the value of the dollar rising?

The main reason why the dollar is gaining is because there is high demand for dollars. The majority of economies’ economic outlooks indicate a significant decline.

In the meantime, the conflict in Ukraine has greatly increased geopolitical risk and market volatility. Additionally, the US Federal Reserve has rapidly raised rates as a result of historically high inflation.

These and other causes are causing a flight to safety, in which investors are selling their holdings in Europe, emerging markets, and other places in search of safety in US-denominated assets, which must clearly be purchased with dollars.

This phenomenon is not brand-new. The invasion of Ukraine has caused the U.S. dollar to initially appreciate more versus EM currencies than it did in response to the 2013 taper tantrum or other conflicts involving oil exporters.

The market is still anticipating swift Fed rate increases. EMs have previously had crises due to comparable instances of rapid rate increases. This was the situation during the “Lost Decade” in the 1980s in Latin America and the Tequila Crisis in Mexico in the 1990s (which then extended to Russia and East Asia). Check out the most recent World Bank Development Podcast if you’re interested in learning more about the debt issues brought on by stagflation.

Debt Worries 

In light of that, anticipate increased stress in the already unstable sovereign debt market.

Many nations, particularly the poorest, are unable to borrow in their own currencies at the levels or for the durations they desire. Lenders do not want to take the chance of receiving repayment in the unstable currencies of these debtors. Instead, these nations typically promise to repay their obligations in dollars, regardless of the exchange rate, when they borrow money. When a result, these repayments become significantly more expensive in terms of native currency as the dollar gains strength in relation to other currencies. This is referred to as the “first sin” in terms of governmental debt.

Who then is doing better? Brazil has done rather well recently, and among East Asian nations, the percentage of debt denominated in dollars is relatively low. The latter has benefited from the enormous dollar holdings of the central bank, the fact that it is a net commodity exporter, and the fact that the private sector appears to have done well to protect itself from currency swings.

Growth Concerns

Other central banks must increase their own rates to maintain competition and protect their currencies when the US Federal Reserve raises interest rates. In other words, investors must be persuaded to put their money into an EM rather than safer US assets by promising them larger returns.

This raises a problem. On the one hand, it is clear that a central bank aims to safeguard foreign investment in the national economy. However, rate increases also raise the cost of domestic borrowing and have a moderating impact on GDP.

The Financial Times recently stated that “foreign investors have taken funds out of emerging countries for five straight months in the longest string of withdrawals on record,” citing information from the Institute of International Finance. Important investment capital is escaping from EMs and heading in the direction of safety.

Finally, a domestic downturn will eventually affect government revenue, which might compound the debt issues already highlighted.

Trade Issues

A rising dollar may also have an immediate negative impact on commerce. The greenback dominates international transactions. Firms operating in non-dollar economies use it to quote and settle trades. Just look at key commodities like oil, which are bought and sold in dollars.

A high dollar can have significant domestic effects on emerging economies, including rising inflation, as many of them are price-takers (their policies and actions have no impact on global markets).

Imports become more expensive as the dollar gains strength, compelling businesses to either decrease investments or spend more on essential imports.

Some people’s long-term trade outlook is more optimistic, but it’s still a mixed picture overall. Yes, import prices have increased due to the strong dollar, but export prices are generally lower for overseas consumers.

Increased exports raise GDP growth and foreign reserves, which helps to mitigate many of the problems mentioned here, therefore export-led economies may stand to gain.

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