Implications Of Rising Dollar Value

Any country’s strength or weakness has an undeniable effect on economy. The strength or weakness of a currency is determined by its capacity to buy certain goods or services in comparison to other currencies. In this regard, US dollar is the benchmark to judge the value of a country’s currency because of its status as the global reserve currency. US dollar has gained recognition as the world’s only international reserve currency. Its acceptance as the global currency is the reason why its changing value has direct implications for economies globally. US economy is no one in the world and so policy measures introduced by the central bank of that country impact the global economy.

History has evidence how US dollar exchange rate fluctuations have damaged economies worldwide. Whenever the value of the dollar goes up or vice versa, there is no escaping from the financial consequences arising from this development. This is why we have seen major financial powers plus the US have struggled to hammer out a strategy that helps the dollar to lose its value in terms of other currencies.

Negative impact

As the dollar’s value has continued to surge for the last few months due to policy intervention by Federal Reserve and America’s central bank, economists are worried about rising dollar’s negative impact globally. They are recalling the 1985 agreement reached among the US, UK, Germany, Japan, among others, in New York to take policy measures that stemmed the rise of the US dollar. Widely known as Plaza Accord, it worked out a strategy that did not allow the dollar’s value to go up beyond certain limit.

That accord prevented the further economic damage due to dollar’s rise in value. Dollar’s appreciation is tantamount to falling value of other currencies. With weakened value of currencies, countries become overburdened as they have to pay more for their imports. Their dollar-denominated debt goes up further limiting their repayment capabilities. It may be in order to explore what has led to the situation that prompts the US currency to go up in value. Definitively speaking, the recent move of the US Federal Reserve to tame increasing inflation in the country is the main reason that has helped US currency to appreciate. Whether this policy initiative of increasing interest rate to bring down inflation is flawless or is associated with other side effects that harm the domestic economy is contestable.

In dealing with inflation, the country’s central banks generally seek an intervention in the capital market by pursuing tight monetary policy. To explain it further, let us take the example of interest rates that either expand or shrink the capital flows in any country. Whenever the government’s central bank decides to cut down the rate of interest, its motive is to facilitate investment as borrowers find it cheaper to invest with lowered rates of interest.

Conversely, when the interest rates are increased, banks attract more money because the depositors have the opportunity to get higher returns from their deposit. Under such circumstances, investors not only from within the country but also from abroad find it more profitable to invest in the country where higher rates of interest are provided. This leads to higher demand for the currency where the central bank has pursued a policy of rising rates of interest.

Demand for US dollar has increased due to added attraction for the greenback luring foreign investors, who often withdraw funds from other investment destinations to invest in US dollar-denominated assets like US treasury bonds. It has dual effects. One is that the economy of the country from where funds have been withdrawn slows down with shrinking investment opportunities. Another is the pressure of demand for the US dollar that further strengthens its value, which indirectly hurts the poor economies, where the large majority of people depend on imports for livelihoods. Imports become more expensive with rising value of dollar.

In the US, inflation has been a headache for the policymakers, particularly the Federal Reserve, the central authority that bears the responsibility of orchestrating appropriate monetary policy that saves the economy from overheating. Inflation can have negative effects on a country’s aggregate real income. This happens when the prices of the goods it imports and consumes rise relative to the prices of the goods it produces and exports.

Commensurate with this, the US Federal Reserve has been favouring tight monetary policy that curtails the money supply so that prices of goods and services could be brought under reasonable control. To achieve this purpose, it has increased the interest rate in order to discourage borrowing which would result in lower investment to prevent overheating of the economy. A quick look at the pace of interest rates change introduced by the US central bank reveals that Federal Reserve has been raising US rates more quickly than has European Central Bank and other banks in major partners. Japan, a major trading partner of the US, remains stick to its ultra-loose monetary policy keeping short-term interest rates close to zero.

Economic fundamentals

US dollar’s appreciation is the widening of interest rate differential between the US and other major economies making greenback more attractive to global investors. Dollar’s recent surge is driven by certain economic fundamentals. As long as the US economy remains better equipped to handle global inflation than its trading partners are and as long as the Federal Reserve continues to hike interest rates, there is every likelihood that dollar stays strong.

Against such backdrop, let the Federal Reserve recall the lost decade of growth in Latin America in the 1980s when its interest rate hikes precipitated a series of debt crises. A strong dollar though mostly great for the US with cheaper imports and lower inflation may paradoxically be harmful if it cools growth abroad, which will feed back into slower growth in the US. Disappointedly, the most vulnerable countries, including Nepal, face the biggest blowback from dollar’s strength.

(Thapa was Foreign Relations Advisor to the Prime Minister 2008-09)