- The value of the U.S. dollar is higher than it has been since the 2000s, and it appears set to keep rising.
- The strengthening of the world's reserve currency will have global repercussions.
- Emerging markets that have borrowed heavily in dollars will bear the brunt of the impact as they find it harder to repay or roll over their debts.
The value of the U.S. dollar is higher than it has been in over a decade, and circumstances in the global economy seem to be pushing it higher still. When the world's reserve currency is as strong as it is now, no country can escape its effects. And for many states in emerging markets that have borrowed heavily in dollars, 2017 could be a rough year as their debts come back to haunt them.
Today, the dollar stands astride the world like a modern colossus. Dollar-pegged countries produce a third of global output, and the dollar is the currency of choice for most commodity trade. It is involved in more than 85 percent of foreign exchange trades, and it is the currency for 39 percent of the world's debt and 63.4 percent of the world's known reserves. In the runup to the 2008 global financial crisis, several analysts pointed to the U.S. trade deficit as evidence that the dollar's days were numbered and predicted that, in a crisis, it would be abandoned en masse. But they were wrong. Massive capital inflows reinforced the dollar's safe-haven status just when its future was most uncertain, a seeming paradox made especially acute by the fact that the United States itself was a key source of the crisis.
The World's Reserve
The dollar's reign can be traced to the 1944 Bretton Woods Conference. The wartime summit saw the sculpting of a new global economic system: Instead of the gold standard, the world's currencies would be pegged to the dollar, which itself could be exchanged for gold. This required countries to hold extensive dollar reserves to manage their pegs, increasing the number of dollars in circulation. The supply only grew under the Marshall Plan, as the United States pumped capital into rebuilding countries ravaged by World War II.
These actions injected dollars into the global system that could be put to good use, and in 1960s London, an offshore currency market developed. The bulk of it was devoted to trading offshore dollars — or eurodollars — often through the issuance of dollar-denominated eurobonds. These offshore markets helped investors who wanted to trade in dollars but did not want to be subject to the U.S. government's political aims or to the taxes and restrictions that can accompany the onshore, or domestic, dollar trade. Over time, offshore markets attracted mostly investors from outside the United States, while U.S.-based investors tended to frequent onshore markets.
The Bretton Woods system broke down in 1971 as the volume of U.S. spending outstripped the available gold, rendering the gold peg unsustainable. Global demand for dollars continued, however, thanks in part to a U.S. deal with Saudi Arabia to denominate oil trade in dollars. The mid-1970s spike in oil prices energized the eurodollar market, facilitating vast loans from newly enriched oil exporters to newly needy oil importers. Since the eurocurrency market was free of regulation, it became a hotbed for economic innovation and gave rise to all kinds of swaps to help companies, countries and supranational organizations such as the World Bank acquire dollars and other currencies while taking full advantage of differences in interest rates among countries.
At around the same time in the United States, government limits on the interest rates that banks were allowed to charge led to the rise of money market funds. These funds buy only high-quality, short-term instruments such as treasury bills (short-term government debt) and commercial paper (short-term corporate debt). The seeming reliability of the assets backing these money market funds allowed them to offer shares at a constant price of $1 each, a promise that was broken only once, in 1994, until the 2008 crisis. These money market funds went on to play an integral role in providing dollars to the international currency market as they channeled U.S. money to safe international assets and passed on the higher returns to their investors.
Then Came 2008
Prior to the 2008 financial crisis, European banks accumulated a substantial amount of dollar-denominated debt. A loosening of regulations on both sides of the Atlantic led to a period of rapid banking expansion as European and U.S. banks repeatedly traded bundles of debt, their leverage covered by fewer and fewer safe assets. The problem the Europeans had was that these liabilities were being amassed in U.S. dollars: When the practice stopped, they were particularly exposed since they did not have a direct link to the Federal Reserve that could give them the stream of dollars needed to cover their debts.
When Bear Stearns and Lehman Brothers went bankrupt, banks rapidly lost faith in one another's ability to pay back loans, and the short-term funding market dried up. The situation was made even worse by the fact that the Reserve Primary Fund — the flagship money market fund — had invested in large amounts of Lehman Brothers debt and faced sizable losses. The day after Lehman Brothers' failure, the Reserve Primary Fund became the second money market fund ever to "break the buck," or drop its share price below $1. Its announcement that shares were now worth only 97 cents triggered an exodus from money market funds by investors who had thought their investments entirely safe. Non-U.S. banks, which had already found their U.S. counterparts unwilling to lend them dollars, now saw another source of dollars (money market funds) disappearing as well. Those funds had invested about $1 trillion in European banks — an eighth of those banks' funding.
Washington felt forced to act, and the day after the Reserve Primary Fund's announcement, the Fed began to set up currency swap lines with other central banks. These links created direct flows of dollars from the Fed, which central banks could then pump into their own dollar-starved banking systems. Existing swap lines with the European Central Bank and Swiss National Bank that had been established in December 2007 were expanded, and new ones were extended to Canada, the United Kingdom and Japan, followed by Australia, Denmark, Norway, Sweden, New Zealand, Brazil, Mexico, South Korea and Singapore. These types of swaps require an element of trust among central banks. In this case, the Fed ran the risk of not recovering its dollars at the end of the swap agreement if ailing counterpart economies failed to recover. It is no coincidence that the recipients of these swap lines could all be considered "friendly" to the United States, and there is evidence to suggest that requests from other central banks were rejected. In any event, the combined actions of these central banks and governments averted further disaster, and the temporary swap lines proved a success. In 2013, the United States, Canada, the United Kingdom, the eurozone, Japan and Switzerland established permanent swap lines among themselves that they could access in times of emergency.
The Foundations of Another Crisis
In response to the 2008 crisis, governments in developed markets followed policies that were designed to prevent the kind of depression the Wall Street crash spawned in the 1930s. Central banks ran ultra-loose monetary policies, flooding the market with money via record-low interest rates and quantitative easing policies, with the United States leading the charge. As a result, dollars have poured into the global market as investors in the developed world found their domestic markets incapable of providing sufficient returns. Emerging markets have received large quantities of capital, much of which has taken the form of growing corporate debt. With foreign investors wary of making loans in local currencies to emerging markets with histories of high inflation and default, dollar-denominated loans have once again come under strain. From the borrowers' perspective, the low interest rates being offered seem too good to be true; problems appear only later on when the dollar appreciates against the local currency and the borrower finds its debt becoming more and more expensive.
In fact, the dollar has been appreciating since 2014. The mid-2013 announcement that the Fed would end quantitative easing bond purchases famously elicited a sharp reaction from some emerging markets. Those deemed overly exposed saw funds flow out of their own pockets and back into the United States in anticipation of a hike in interest rates. But the expected series of increases has come more slowly than initially predicted, partly as a result of a collapse in commodities prices that created deflationary pressure, causing the dollar to level off. The currency's value has stayed contained to a high but narrow range for the past two years. But signs have surfaced that interest rate hikes will soon speed up: Commodities prices have stabilized and inflationary pressures have begun to appear. Expectations of rate increases rose even further when Donald Trump was chosen in November to be the next U.S. president. (His platform contained high spending and protectionist policies that appear to be a recipe for inflation.) The market immediately began pricing predictions of more rate hikes into the dollar, whose value has risen steeply once again.
Meanwhile, its price is not the only constraint that has emerged around the dollar. New laws aimed at staving off a repeat of the 2008 crash have restricted the activities of banks around the world. Liquidity coverage ratio requirements have forced banks to keep more of their money in reserve, reducing the amount that they can put into the market.
At the same time, the new rules allow money market funds to limit investor withdrawals if they need to fend off the type of flight they saw during the last crisis. The reforms change the pricing of these funds' shares to correspond with their underlying assets as well, removing the $1 promise. From an investor's perspective, this reduces the value of money market funds, which previously provided a haven for money yet kept it available for withdrawal in full at any time. Consequently, by the time these reforms took effect on Oct. 14, prime money market funds had lost more than $1 trillion to more reliable government debt funds.
These developments have raised the costs for offshore investors looking to exchange U.S. dollars on the open market, since shrinking money market funds and tight banking regulations have taken many dollar providers out of the system. The upshot is another uptick in the costs for issuers of offshore debts denominated in dollars to roll them over or pay them back. Should a large number of companies, and thus their governments, run into trouble for lack of dollars, the United States might again come under pressure to dole out dollars through central bank swap lines to satisfy the international community's need. Given the lukewarm relationship between the United States and many of the countries likely to be affected by a squeeze on the global dollar supply, some requests could easily go unfulfilled.
Who's in Danger?
The countries most at risk from a strong dollar are those with hefty dollar-denominated debts. Ample foreign exchange reserves can help offset this problem, since they can be used to prop up national currencies or pay off corporate debts in a pinch. On the downside, a current account deficit (which arises when a country spends more abroad in its day-to-day activities than it receives) would exacerbate the issue, since it implies that money is naturally flowing out of the country.
The 2013 "taper tantrum" revealed five countries to be particularly at risk because of their large current account deficits and dollar-denominated debts: India, South Africa, Indonesia, Turkey and Brazil. But over the past three years, most of these countries have improved their financial standing and are less vulnerable than they were in 2013. The so-called Fragile Five could still be somewhat exposed, but now they are part of a much bigger pack.
A Gloomy Outlook for Many
Forecasting the future of currencies is a notoriously risky business. Forces may push them in a particular direction, as is currently the case with the dollar, but in the ever-changing environment of the foreign exchange market, events anywhere in the world, at any point in time, can alter their course. In 1985, for instance, the world's leading governments came together to sign the Plaza Accord and forcibly rebased their currencies against one another, ending a runup in the dollar. A similar intervention seems unlikely at this point.
Nevertheless, the dollar is steadily strengthening, and it could create headaches in other parts of the world. One of the biggest victims will be China. The Chinese yuan has been devaluing against the dollar for the past 18 months, a process that in itself leads to capital flight as investors try to flee the depreciating currency. This carries the risk of becoming a disorderly process, and China has spent a considerable share of its foreign exchange reserves to manage it. These reserves now stand at $3.1 trillion, still a giant figure but down 25 percent from what it was in 2014. A strengthening dollar will put more pressure on China to burn through its remaining reserves even faster, eating away at the safety net it has built up over the past two decades.
But the most exposed countries are the ones, mainly in emerging markets, that are saddled with significant dollar-denominated debts and do not have abundant foreign exchange reserves to fall back on. Many of these countries' finances have improved since the taper tantrum, but as the dollar strengthens, they will find it harder to repay or refinance their debts, especially as the cost of swapping dollars on the open market rises. By all appearances, the strengthening dollar is an omen of the difficult year ahead for the world's emerging markets.
Editor's note: The graphic depicting those countries most affected by a strengthening dollar has been updated to show additional information.