Dec 8, 2016 | 18:23 GMT

2 mins read

Where a Strong Dollar Will Do the Most Damage

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Where a Strong Dollar Will Do the Most Damage

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. 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 trying to manage it. 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.

Still, 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.

Many emerging markets are saddled with significant dollar-denominated debts, too, and do not have abundant foreign exchange reserves to fall back on. Some of these countries' finances have improved since the taper tantrum, but as the dollar's value rises, 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.

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