USD strength has a dark side

In normal circumstances, indications of continued strength in the USD wouldn’t be a concern for the global economy.

By Francesca Fornasari, Head of Currency Solutions

All views as at 19 May 2020.

These are not normal circumstances and what started as a moderately stronger USD has developed into a sinister force which threatens assets sensitive to the global economic cycle. The influence of coronavirus has accelerated this issue. In the last few weeks liquidity has been seriously tested, even in the currency space. If the measures announced so far don’t calm the markets, we may even see currency intervention make a come-back.

Markets have pushed the US Federal Reserve’s own measure of the Broad US dollar index to all-time highs. Normally this would not be a problem for the global economy. In theory, it is the US economy that should be most negatively impacted by a stronger US dollar as its exports lose competitiveness versus peers. But, there are sound economic reasons to discount the negative impact of a stronger US dollar on the US.

The impact of a stronger US dollar on the US economy should be limited

1. Empirical estimates suggest the impact of the currency on domestic trade is likely to be limited.
Indeed, US trade has the second lowest sensitivity to currency moves amongst developed and large emerging market countries. This is likely to be due to a variety of factors, ranging from the relatively small size of the export sector relative to GDP, to the extensive integration in cross border production chains. When the currency appreciates, the negative impact on the competitiveness of the final product is cushioned by the fact that imports become more competitive. When we consider the impact on inflation and consequent impact on monetary policy, we get a similarly benign picture as empirical literature suggests that the disinflationary impact of a strong US dollar has generally fallen over recent decades. This is not a surprise, as companies don’t just set prices to protect margins, but also look to protect market share, thereby loosening the link between exchange rates and inflation.

2. Conversely, theory also suggests that countries finding themselves with a weakening currency should benefit. While this is likely to be true for countries that are more open than the US and with a larger percentage of value added in the exports, US dollar strength (and local currency weakness) could be more problematic for countries relying on US dollar funding, especially emerging markets. Indeed, the BIS has empirically shown that a stronger US dollar is associated with lower growth in US dollar-denominated cross border flows and lower real investment. Historically, the impact through the trade channel has been thought to be greater than that through the financial channel, but this is no longer clear given the rise in hard currency debt – according to the BIS:

  • US dollar-denominated debt of non-banks outside the US has grown to $12tn of which $3.8tn are owed by emerging markets,
  • This is more than double the level in 2010 
  • Equivalent to roughly 18% of emerging market GDP.

Moderate US dollar strength is manageable for the world

This would suggest that moderate US dollar strength is something the global economy could cope with. Unfortunately, what started as a moderately stronger US dollar due to US economic ‘exceptionalism’ has morphed into something more sinister that reflects an acute shortage of US dollars for non-banks outside the US and significant capital outflows from assets deemed to have a higher beta to the global economic cycle, such as emerging markets. Both are likely to acerbate the economic impact of the coronavirus, which Insight tentatively estimates to have a peak to trough impact of as much as -15% of GDP for major economies. As the US dollar strength is the symptom, rather than the cause, policymakers have rightly focused on implementing an unprecedented level of fiscal, monetary, and liquidity support. Currency intervention to lower the US dollar is the one policy option that has yet to be used by developed market central banks.

Intervention is not guaranteed to succeed

The track record of currency intervention in changing the trend of a currency is chequered at best. Some recent studies have shown a success rate of around 60%, but crucially only examine the impact during the intervention and not in the medium or long term. Even in the case of the Plaza Accord – widely regarded as one of the most successful attempts to turn the US dollar – it is not clear whether it was the G7’s coordinated currency intervention or other events such as the peaking of US real yields that helped to drive the USD 19% lower.

Other challenges that stand in the way of successful intervention to lower the US dollar are:

  • lack of excessive long US dollar positions and,
  • the fact that the currency markets are distinctly larger and most likely harder to manipulate than they were in the mid 1980s

According to the BIS, the average daily turnover in the currency markets is $6.6tr, 80% of which is versus the US dollar. This would suggest that policymakers around the world have been right to focus on other macro policy tools to support growth.

Central banks and finance ministries do, however, need to maintain liquidity in dysfunctional markets. Despite its shortcomings, currency intervention might be the last tool they have left.

 

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