With the value of the U.S. dollar undergoing unprecedented declines, global central banks are under increasing pressure to defend their currency value. For more than 15 years, the Swiss National Bank (SNB) has been waging an unsuccessful war on a strong franc. At the same time, the dollar index has fallen over 9% already this year! Analysts predict further declines in the dollar index. They call this partly ongoing uncertainty over U.S. policymaking and recently a more serious flight from the dollar and U.S. Treasurys by investors.
The dollar’s broad decline puts emerging markets in a bind. Central banks in Asia are quickly coming under the gun to consider currency devaluations. Yet these decisions are not without risk: they may provoke capital flight and even charges of currency manipulation. The Japanese yen, which has already shot over 10% against the dollar since the beginning of the year. This underscores the uneven impact of a depreciating dollar on other currencies.
The dollar index’s dismal state is due to many factors, but foremost among them is a complete loss of confidence in U.S. economic policies. That continued uncertainty has contributed to a profound dollar detox, with investors flocking to currencies other than the dollar.
Emerging market economies, especially those in Asia, are in a very tight spot. They have to weigh the risks of currency instability against those of capital flight, a loss of macroeconomic control, and a panoply of other threats. There are a few critical factors that try to predict a currency’s ability to devalue. These factors encompass foreign exchange reserves, exposure to foreign debt, trade balances and sensitivity to imported inflation.
As analyst Brendan McKenna wrote, it’s an incredibly difficult set of choices that these countries must make.
“Export-oriented countries with sufficient reserves and lower reliance on foreign debt would have more room to devalue – but even those are likely to tread carefully,” – Brendan McKenna.
Central banks are more engaged than ever in judging their approaches. To their credit, they understand that devaluation will likely incite retaliatory moves from other countries, further destabilizing the global economy.
For some governments and central banks, a weakening U.S. dollar is a welcome relief. An analysis reveals that a net 61% of participants in Bank of America’s Global Fund Manager Survey expect the dollar’s value to decline over the next year. Economist Adam Button put this feeling into words.
“Most central banks would be happy to see 10%-20% declines in the U.S. dollar,” – Adam Button.
Other currencies are rising and the safe havens are high, especially Swiss franc and the euro. Both have appreciated ~11% against the dollar this year, illustrating where the power has shifted in foreign exchange markets. These movements show how different countries are dealing with the dollar’s depreciation and how they’re adjusting their monetary policies in order to adapt.
Emerging markets are most susceptible in this context, grappling with entrenched high inflation and an acute debt overhang. As Wael Makarem, a fellow agent of financial realism recently noted, we shouldn’t underestimate the tight corner these economies have been painted into.
“Emerging markets face high inflation, debt, and capital flight risks, making devaluation dangerous,” – Wael Makarem.
Though countries might be tempted to use devaluation as a tactical move, they need to proceed with care given the risks involved. Button added that if the current capital flight from these economies continues, desperate measures will need to be taken.
“If capital continues to flow in, they may have to take drastic measures to devalue,” – Button.
During the last inflationary era, in Europe, central banks were quick to catch on to what was happening. Representatives from the European Central Bank stated that most measures suggest inflation will stabilize around their medium-term target of 2%. These sorts of forecasts can have a major impact on how central banks decide to position their currencies in the face of external pressures.
All in all, international central banks are over a barrel as they figure out what a weakening U.S. dollar could mean. The relationship between currency stability and economic growth is nuanced, requiring thoughtful reflection from policymakers all over the globe.