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How A Strong Dollar Hurts Europe And Emerging Markets

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Are all strong dollars good? It depends on where you sit in the global economy.

Indeed, the dollar these days is almighty. Dollar Index, which measures a currency’s strength against other major currencies It has been at its highest level since April 2002, more than 20 years..

This is not too surprising as rising interest rates tend to attract capital from abroad. In America’s case, the Federal Reserve has dealt with inflation more aggressively than any other central bank. This was achieved by raising the cost of short-term borrowing from less than 1% earlier this year to 3.25% recently. As a result, the dollar has become the king of currencies.

A strong dollar is certainly positive for the US, as Forbes contributor John Tobey outlines here.

However, if you’re not in the US, a strong dollar can be bad, really bad, or excruciatingly bad. It depends on where you live.

european dollar problem

The spike in inflation in Europe is quite different from the US problem. The surge in the US cost of living is largely due to his massive fiscal stimulus during the COVID-19 pandemic.

In Europe, it is due to the energy supply shock following Russia’s invasion of Ukraine.

A stronger dollar affects the European Central Bank, which controls the euro currency, and the Bank of England, which controls the British pound.

Both banks are in a stalemate. Both know that raising interest rates will not help inflation in Europe. Because no matter how high the borrowing costs, we cannot supply Europe with more energy.

But at the same time, central banks know their currencies will depreciate if they don’t raise rates much like the Fed did. In both cases, this is the bank’s decision.

The euro is currently trading just under $1. It is down from about $1.17 a year ago. Similarly, about 1 year The pound will trade at $1.39 against recent 1.16.

And then there is friction. Countries with depreciating currencies tend to import inflation. This is because most things in the world are priced in US dollars.

Simply put, Europe’s central banks had to decide between raising interest rates to crush a weakened economy or importing inflation. So far they’ve opted for the latter, and the results will be bad, but probably not that bad, or terribly bad.

emerging markets

Economies that have not reached the level of developed countries such as Western Europe, the United States, Canada, and Japan are commonly referred to as Emerging Markets (EM).

Unlike Western governments, some emerging economies borrow US dollars rather than sell bonds denominated in their local currency.

For example, Indonesia has USD loans equivalent to over 7% of GDP in 2020.

That means that the steady decline in the value of Indonesia’s currency, the rupiah, this year will make its debt an even bigger problem for the Indonesian government. Finance ministers must either buy increasingly strong dollars in the market to pay interest on debt or deplete the country’s dollar reserves. As foreign exchange reserves have been steadily declining this year, they have opted for the latter.

Other countries are similarly exposed. The good news for Indonesia is that it is exporting commodities that have performed well overall this year. Its economy is growing very well.

But if the dollar continues to soar, Indonesia and similar emerging economies with dollar-denominated debt could find themselves in financial trouble. Certainly, this is very bad compared to the problems facing Europe. But it’s not excruciatingly bad.

Frontier Markets

There are economies that are weaker than those classified as emerging. They are known as frontier markets and are economically vulnerable. One example is Pakistan, which had EM status for a while but is back again, thanks in part to the COVID-19 pandemic.

Capital fled to the safety of the US Treasury when the US and Europe ordered a halt to economic activity in late March 2020. The Pakistani Rupee fell against the dollar to then-record lows while the dollar rose.

Despite Pakistan’s optimistic outlook pre-pandemic, investors began to withdraw money from the country as the crisis progressed. What followed was the continued depreciation of the rupee and an increasingly struggling economy..

The country had EM status during the health crisis but was quickly relegated to frontier status. The recent continued strength of the dollar seems to have made matters worse.

Pakistan’s GDP per capita is expected to decline from around $1,500 in 2019 to $1,250 by the end of 2022. According to Trading EconomicsOf course it doesn’t help anyone in the country.

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