The U.S. dollar has strengthened to a 20-year high against a group of foreign currencies, making loan payments owed in U.S. currency more expensive and increasing the potential for a global currency crisis.
Some heavily indebted smaller countries around the world have already defaulted on their international debts, including Zambia, Lebanon and Sri Lanka.
The strengthening U.S. dollar threatens to make Argentina’s 70-percent-plus inflation worse, NPR reported.
U.S. interest rate hikes like the ones handed down by the Federal Reserve often spell disaster for lower-income countries, said Francesc Balcells, who manages emerging market debt at the Dubai-based Frontier Investment Management Partners.
Poorer countries have larger debts in U.S. currency and they are now also having to pay more for imports bought in dollars as the currency strengthens. This is happening as global prices for food and fuel surge due to currency fluctuations and supply shortfalls caused by Russia’s invasion of Ukraine.
The most recent emerging market meltdowns, including the Asian financial crisis in the late ’90s always coincided with periods of interest rate hikes in the U.S., Balcells said.
The number of emerging market borrowers that have debt trading at distressed levels has doubled in the last six months, Bloomberg reported.
Many of the larger middle-income countries can weather that storm, Balcells said. But it’s a “perfect storm for emerging markets.”
People in Ghana and Nigeria, the largest economy in Africa, are also facing financial distress.
Increases in food prices hit poorer households harder than wealthier ones. Food makes up 40 percent of the consumer price index in sub-Saharan Africa and less than 20 percent of the CPI in advanced economies, according to International Monetary Fund estimates.
The U.S. dollar has soared in 2022 amid global recession fears and the Federal Reserve’s aggressive interest rate hikes.
Fueled by the Fed’s most aggressive interest rate hikes in more than a generation, the stronger dollar is pushing down the value of other currencies, driving up the cost of imported goods, and feeding inflation in other economies.
That is putting pressure on other central banks to raise interest rates at a time when an energy crisis and skyrocketing consumer prices are already impacting their economies.
“Their ability to influence the dollar’s strength is limited, meaning there’s little prospect for near-term relief,” Fortune reported.
The U.S. was the first to enter into a rate hike cycle and that inflated the value of the dollar “because if you buy dollar assets, you’re going to get more interest rate return on it as a result,” said Martin Baccardax, London bureau chief for The Street.
“People often tend to go into the U.S. dollar when they’re feeling a little bit risk averse, they see it as a safe haven,” Baccardax said. “It stands to reason that people would be buying U.S. dollars in order to be more protective as they take risk off the table. That inflates the value of the dollar as well … it does increase the pricing and purchasing power for American consumers, but there’s a flip side to that.”
While it does increase purchasing power, “it has that diminishing aspect with respect to earnings potential,” he added. “Ultimately, whilst it’s good to have a strong dollar, it’s not good to have a seriously strong dollar because of the things that it speaks to in the global economy.”
The euro fell on Monday to its lowest level against the U.S. dollar in 20 years, sinking below $0.99. This downward movement came after the G-7 group of wealthy nations agreed to impose a price cap on Russian oil and Russia’s Gazprom responded by announcing it would shut off gas supplies indefinitely to Europe through the Nord Stream 1 pipeline.
Investor bets that the euro would fall in value reached their highest level in more than two years in late August, reflecting bullishness on the U.S. dollar, according to the Commodity Futures Trading Commission. Speculators built up net short positions in the largest bearish position against the euro since the beginning of the pandemic when the eurozone economy plummeted by a record postwar contraction.
Rising bets against the euro reflect the role of the dollar as “a safe port in a storm” as well as the fact that the U.S. is not as exposed to the gas crisis, said David Adams, head of G10 FX strategy at Morgan Stanley.
Betting against the euro has its own risks. The longstanding “flow of money” away from Europe to invest in the U.S. and other regions could reverse in the next six to 12 months as the European Central Bank raises rates, making eurozone bonds more attractive, Adams said.
The British pound also fell Monday against the dollar to $1.1475 – its lowest level since 1985 — ahead of the announcement that Liz Truss, the fourth British prime minister in six years, would be next to assume the position.
The British pound has been hammered over recent months by surging inflation — the highest among all G-7 nations.
Truss inherits an economy dealing with the worst cost-of-living crisis in a generation, with inflation hitting 10.1 percent in July. Deutsche Bank warned Monday that the risks of a “sterling crisis” should not be underestimated.
Bank of England chief Andrew Bailey dismissed the idea of a looming U.K. currency crisis. “But the rare sight of the pound and UK government bond prices falling in tandem ever since sounds an alarm bell that there’s something more awry than a love for the dollar or the ebb and flow of volatile currency markets,” Mike Dolan wrote for Reuters.
Japan, the world’s third-largest economy, saw the yen sink to its weakest value versus U.S. dollar since 1998. Japan’s currency — the second-most traded with the dollar — is close to the 146 mark that prompted joint action with the U.S. in 1998 to prop it up, Fortune reported. The yen has seen a 40-percent climb of the USD/JPY since late 2020.
“I see more pain ahead for those long the yen,” wrote Mike Zaccardi, an adjunct finance instructor at the University of North Florida, for Investing.com. “Erik Nelson at Wells Fargo concurs—he expects USD/JPY to touch 150 later this year.”
Examples of currency crises that led to recessions include the crisis in the Weimar Republic in Germany after World War I, the Mexican peso crisis of 1994, the Asian Crisis of 1997, the 1998 financial crisis in Russia, the Argentine crisis in the late 1990s, the economic crisis in Venezuela in 2016, and Turkey’s crisis in 2016.
What could slow the crisis?
One possibility for relief for a potential currency crisis would be a slowdown in the U.S. economy that takes the steam out of the Federal Reserve’s pace of tightening, and by extension, causes the dollar to weaken.