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American travelers may be rejoicing that a night in Rome that once cost $100 now costs $80, but it’s a more complicated picture for global companies and foreign governments.
A dollar surplus is hurting some vulnerable economies.
“It’s been a challenging environment,” said William Jackson, emerging markets economist at Capital Economics.
Why the ‘dollar smile’ leads to frustration
The U.S. dollar tends to rise in value when the U.S. economy is very strong, or somewhat conversely, when it is weak and the world faces a recession.
In both cases, investors see the tide as an opportunity to lock in the country’s currency growth or as a relatively safe currency to stop.
Because it occurs at both extremes, the phenomenon is often called the “dollar smile”.
But the rest of the world is less about the smile. Manik Narain, head of cross-asset strategy for emerging markets at UBS, identified three main reasons why a stronger dollar could hurt smaller economies around the world.
1. Fiscal pressure may increase. Not all countries can afford to borrow money domestically because foreign investors lack confidence in their institutions or have less developed financial markets. That means some have no choice but to take out dollar-denominated debt. But if the value of the dollar rises, that drains government coffers and makes it more expensive to service their debt.
It also costs governments or businesses to import food, medicine, and fuel.
2. Feeds capital flight. When a country’s currency weakens dramatically, wealthy individuals, companies, and foreign investors begin pulling their money out of safe havens. That devalues the currency, exacerbating fiscal problems.
“If you sit in Sri Lanka these days and see the government being pressured, you want to get your money out,” Narain said.
3. Weigh on progress. If firms can’t buy the imports they need to run their businesses, they won’t have as much inventory. This means that even if demand remains strong when weighing on the economic performance, they will not be able to sell as much.
As the US economy continues to falter, that may mitigate some of the damage. Many emerging markets export goods to the world’s largest economy. But when the dollar strengthens because America is on the brink of recession? It’s hard.
“This could cause more pain in the market because you don’t have the silver lining of better economic growth in the background,” Narain said.
Problematic
The dollar retreated 0.6 percent last week. But it is not expected to change course in any meaningful way anytime soon.
“We look for dollar strength to remain largely intact over the medium to medium term,” Scott Warren, senior global market strategist at Wells Fargo Investment Institute, wrote in a note to clients.
This is prompting investors and policy makers to ask if Sri Lanka is the first domino to fall. Also, turbulence in emerging markets can spread throughout the financial ecosystem, causing widespread spillover effects.
But there are also key differences between the current situation and past crises.
Debt paid in dollars is less than before. Big players like Brazil, Mexico and Indonesia – “generally did not borrow much foreign currency and now hold enough foreign currency to manage their foreign debt burden.”
Additionally, commodity prices such as oil and base metals are high. That helps emerging economies that are major exporters, including many in Latin America, and serves as a safe way to ensure that dollars are still flowing into government coffers.
Still, much may depend on the fate of the world’s two largest economies, the United States and China. If these growth engines do indeed start to stall, emerging markets may see disappointing investment flows.
Robin Brooks, chief economist at the Institute of International Finance, said: “It will be critical for the United States to go into recession.” “It makes everyone more vulnerable.”
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