A Strong US dollar is Affecting Both Emerging Economies and the UK
Updated: Nov 15
The dollar squeezes and the world's currencies catch a cold
John Connally, former secretary of the US treasury, once remarked that ‘The dollar is our currency, but it’s your problem’. The last year has shown that a strong dollar has created issues for both developed and emerging markets and, when coupled with persistently high inflation, is contributing to the crippling of economies.
The US dollar is strong relative to other global currencies, which is profoundly affecting both emerging economies and the UK. This strengthening begins with the Federal Reserve, who have been hiking interest rates in order to deal with inflation. While this makes the dollar a more attractive investment given the returns available, there are other factors contributing to the trend. As the global reserve currency, the US dollar is seen as a safe haven in times of uncertainty and market volatility. With a cost-of-living crisis, high inflation, and the Russian invasion of Ukraine, it is no surprise that these have all led to a stronger dollar. Moreover, America’s economic health is better than most, another attractive factor for investors.
Emerging Markets (EM)
Many emerging economies, who have already suffered from the pandemic, are facing increased pressure on their finances due to a strong dollar. Having already imported inflation through higher food and energy costs resulting from the Russian invasion of Ukraine, they must now use more of their own currency to purchase imports given the dollar’s strength. This further exacerbates the issue of imported inflation. Furthermore, most of these nations have extremely volatile currencies. As a result, investors – even in the best of times – are unwilling to lend as they don’t wish to risk being repaid in these domestic currencies. Instead, EM economies are forced to borrow in US dollars, and therefore pay interest in US dollars. When the currency strengthens, it further cripples their finances and puts many on the brink of default. The appreciation of the dollar in such circumstances is called the ‘original sin’, and it is seriously affecting developing countries worldwide.
S&P Global Ratings have said that four EM countries have so far defaulted on their debts, with a further ten in ‘severe distress’. One might assume that, to stay competitive and tackle inflation, these nations must hike interest rates. However, this creates further issues in that their burden of repayments is worsened and, when coupled with the woes associated with the dollar, often proves too much for these economies.
By July this year foreign investors had been pulling out of EMs for five consecutive months. According to the Institute of International Finance, outflows from EMs between February and July amounted to $38bn, the longest period of net outflows since records began in 2005. This is crippling economies, reducing domestic activity, and further feeding the existing debt issues elucidated above. These EMs are in something of a ‘Catch 22’, and the appreciating dollar is not proving helpful.
The UK is a net importer and, in the four quarters up to the end of Q1 2022, the US was the UK’s largest import market, accounting for 12.7% of total UK imports. With a strengthening dollar and a slumping British pound, this has the effect of increasing the cost of imports and dampening the UK economy. The UK imports 50% of its food, all of which will be more expensive with a weaker pound and thus further contributes to inflation and the cost-of-living crisis.
When combined with political turmoil, a disastrous mini-budget that led to Liz Truss becoming the shortest serving PM in history, and severe issues in the gilt market, it is safe to say the UK economy is not in terrific standing. In fact, the rating agency Moody’s recently adjusted their forecast for UK economic outlook from ‘stable’ to ‘negative’. The rating is a marker of how likely the country is to repay its debts. This combination of a strengthening dollar and weak pound has contributed to negative sentiment towards UK investment. It instils a lack of confidence in the currency and increases borrowing costs. At the time of writing, the yield on the 10-year gilt is 3.83%, compared to a yield of 2.7% for the Irish ten-year bond.
It's not all negative, however, for the British economy. American tourists, armed with a strong dollar, are snapping up transatlantic flights as they seek to make the most of the situation. United Airlines, for example, flew 14% more seats across the Atlantic this summer than it did in 2019. The Norwegian start-up North Atlantic flew its first service between New York and London in August, and described the demand for this particular route as ‘especially strong’. The hope is that these Americans then spend big in the UK, helping to stimulate economic activity and growth. But this is a long shot. When contrasted with political uncertainty, disastrous economic policies that have been critiqued by the IMF, and a fifth Tory PM in six years, the negatives of a weak pound outweigh the benefits of a strong dollar.
It appears that Connally was correct. The dollar’s strength is not America’s problem, and so the issue needs addressing by other economies. Until then, however, the currency’s strength continues to cause destruction worldwide.