The appreciation of the dollar threatens the global economy
The Fed’s liquidity fire hose has supported the government’s massive fiscal response to COVID. Through unprecedented asset purchases, the Fed provided enough liquidity to allow the US Treasury to significantly increase its debt burden at historically low yields. Its stocks supported asset markets and weighed on the dollar in the process.
The Fed is starting to cut back on liquidity and the world markets are starting to shake. The, for its part, is on the rise, and with it, underestimated consequences.
Most investors know that the appreciation of the dollar makes imports cheaper for the United States and more expensive for other countries. As such, the dollar affects countries that gain or lose competitive advantages in world trade.
Less appreciated, the US dollar is not only the currency of the United States, but that of the world. Its value against other currencies greatly affects borrowing costs for foreign entities.
As a result, the Fed significantly influences global economic activity through its monetary policy.
Before discussing the Fed’s impact on the global economy, it is worth briefly reviewing the role of the dollar in the postwar era.
One of our most critical macroeconomic articles is Triffin Warned Us. The article describes the Bretton Wood Accord of 1944 and the Robert Triffin Paradox.
“By decree of the Bretton Woods Agreement of 1944, the US dollar supplanted the pound sterling and became the world’s reserve currency. The agreement ensured that a large majority of world trade would be conducted in US dollars, whether or not the United States was involved in that trade.
Since 1944, the United States has suspended convertibility of the dollar to, and most countries allow their currencies to float against the dollar instead of remaining fixed. These were two key tenants of the agreement which no longer exists. While the terms of the deal may be zero, the dollar remains the world’s reserve currency. With this, the Federal Reserve is de facto the central banker of the world.
By the way, Robert Triffin recognized the advantages inherent in a global reserve currency, but also its “paradox”. Triffin argues that the benefits of a reserve currency will create global imbalances and a “tipping point or inevitable failure.
How the dollar affects global liquidity
When a Canadian tire company purchases rubber from a Philippine rubber producer, payment is usually made in US dollars. Both countries have their own currencies, but neither has liquidity and, quite frankly, the world’s largest economy and military power backs it up. For these and other reasons, most foreign trade recipients prefer to receive US dollars.
Because so many countries and foreign companies do dollar transactions, they often borrow in dollars and hold dollar reserves. They do this despite the fact that their income is often not in dollars. It also helps that dollar funding can be cheaper due to greater liquidity in the US credit markets.
However, with dollar funding and dollar appreciation come with dollar risk.
Loonie Tire Company
Consider Loonie Tires, a hypothetical Canadian tire company, and the currency risk it takes when borrowing in dollars. This analysis helps to understand why the value of the dollar is such an important determinant of borrowing costs and, therefore, a global economic backbone.
On June 1, 2021, the Loonie Tire Company borrowed US $ 10 million for one year to purchase rubber. They hope to sell the tires in Canada for the equivalent of $ 12 million. Interest on the debt is $ 500,000, assuming an interest rate of 5%. The transaction is expected to result in a profit of $ 1.5 million or 15% assuming no other expense.
The tire company borrows in US dollars, but the sale of tires is done in Canadian dollars.
On June 1, 2020, one of them bought US $ 0.83. Since then, the appreciation of the dollar against the Canadian dollar has resulted in an exchange rate of 0.78 US dollars per Canadian dollar.
Loonie’s new income statement
Assuming the US dollar / Canadian dollar relationship stays the same, Loonie’s expected profit drops from 15% to 7.77%. Indeed, the cost of borrowing is not 5% as they assumed but almost 13%. If the loan matures today, Loonie would have to repay nearly $ 800,000 more in principal and $ 40,000 more in interest than originally planned.
Suppose that future currency exchanges are not hedged, as in our example. In this case, foreign borrowers of US dollars are subject to higher borrowing costs if the dollar rises against their local currency. Simply the local currency depreciates against the dollar; therefore, they need more local currency to repay their debt. As a result of this construction, the appreciation of the dollar effectively tightens financial conditions on the rest of the world.
In recent months, the Federal Reserve has adopted a more hawkish tone. Economic activity is more robust in the United States than in most countries of the world, and it is higher. The rationale for stopping QE and raising rates is palpable. Currency markets are signaling that through a stronger dollar, the Fed will remove emergency housing faster than most other countries.
As a result, the US dollar index has appreciated 7.7% this year to date. The list below shows by how much the selected currencies have depreciated against the dollar during the same period.
- Canadian $ -1.3%
- $ -9.0%
The only major currency to appreciate against the dollar is the (+ 2.5%).
The value of the dollar does not influence the cost of debt for domestic borrowers in the United States. As we describe in the Loonie example, the opposite is true for foreign borrowers.
As the dollar appreciates, foreign borrowers of US dollars need more US dollars to pay interest and principal on the loan. When borrowers raise the dollars they need to meet their obligations, they cause the dollar to appreciate further. Sometimes, especially during a crisis, when many borrowers are forced to take such action, a global dollar rush occurs and pushes the dollar considerably higher, exacerbating the problems for dollar borrowers.
The Fed’s hawkish tones and robust economic growth are fueling the dollar’s strength. Although the Fed does not directly manage the monetary policy of foreign countries, it profoundly affects financial conditions abroad. Assuming current trends continue, the Fed’s words and actions and the resulting dollar reactions will increasingly become an important factor to watch.
Why should we care about foreign borrowers and global economic activity?
The chart below shows the strong correlation between the OECD leading economic indicator in the United States and its broader index for the world economy.
There’s an old saying that America catches a cold and the world catches the flu. Could the Dollar and the Fed make the world catch the flu, causing Uncle Sam to sniffle?