Far-reaching costs of a dominant dollar

Popular theories include the slowdown in China’s economy, a deceleration in global earnings, or complacent investors ignoring inevitable market risks. For me the glue that not only binds many of these theories but also helps inspire such moves in the first place is the US dollar.

Or, more specifically, the strength of the US dollar.

The US dollar is still the premier player in global cross-border financial flows, but its widespread adoption as a denomination for equity, debt and commodity products over the past few decades has left a problematic legacy if the currency goes up in value.

In the few years after the global financial crisis of 2008-9 the value of the US dollar broadly went sideways, reflecting a general period of low foreign exchange rate volatility. However, over the past year the value of the US dollar has risen by more than 15 per cent and this reality, combined with a few other factors, has helped create a perfect storm for a number of key financial market groupings.

For companies and countries highly exposed to commodities and resources denominated in dollars, the prices of these goods have gone up because the dollar is stronger against the local currencies of these firms and countries.

This sounds like good news but higher prices usually lead to lower demand too. Mix in the added burden of institutions or individuals having to repay corporate, personal or government debt, which is often US dollar-denominated, and before long you have a crisis for commodity producers and any firm or country outside the US with debt predominately in US dollars. In short, one or other of these descriptions covers most of the emerging markets.

And of course this is dynamic. As the credibility of an emerging market’s economic policy starts to wane, this tends to feed through into its currency, accentuating the burden of the strong US dollar and inexorably leading to lower growth and possibly recessionary forces. That is why there was such a furore after the value of the Chinese yuan moved in late August.

In combination, this explains why emerging markets have struggled so much over the past year or so.

And the developed world is not immune too. First, the impact of an emerging market slowdown hurts a good source of export growth. But the biggest effect on the developed world is that a higher US dollar helps cover up structural issues.

Take a look at the eurozone and Japan, two regions that have struggled to post economic growth rates akin to the US over the past few years.

Unsurprisingly this is a reality that is worrying for policymakers in both regions. And what have been their policy responses? Apply quantitative easing… and quietly hope their respective exchange rates slide against the US dollar to help boost growth and price competitiveness.

As the great monetarist economist Milton Friedman once noted, changing the exchange rate is a simple way to change all the prices in an economy in one fell swoop.

This has not been healthy for either region. The eurozone’s trade surplus would suggest it needs a higher not lower exchange rate. More worryingly both areas have had negligible local growth rates as consumers and businesses feel reluctant to spend in response to sclerotic labour markets, inhibited entrepreneurship and prohibitive regulation and taxation.

Rather than apply much-needed supply-side reforms, both the eurozone and Japan have relied on a weak exchange rate against a rampant US dollar as an easy prop – a solution that may help a little in the shorter term but hurts longer-term prospects.

And it is a reappraising of these longer-term prospects that ultimately hurts the stockmarket. A stronger US dollar harms emerging markets and prevents necessary reforms in a number of key developed markets. This is neither good for the world nor its financial markets.

So can the US dollar easily, magically fall? The final missing piece of the story is its impact on the US economy.

A higher US dollar is crimping US corporate earnings growth – another source of the recent volatility in financial markets. A change to the current, broadly consensus view that everything is wonderful in the US economy is just the sort of economic occurrence that can send the US dollar southwards… to the imbalance-reducing benefit of all.

Chris Bailey is a European strategist at Raymond James