TOKYO – Everything currency traders thought they knew about financial gravity is being challenged by the dollar’s surprising bull run. The reasons why the US currency should be stumbling are almost too many to list.
They include the swelling of Washington’s twin budget and current-account deficits, signs that ultra-loose Federal Reserve policies are here to stay, ongoing fallout from former president Donald Trump’s disastrous trade war and Covid-19 response, Beijing’s efforts to internationalize the yuan and China’s world-beating economic recovery.
Where things are headed in 2022 also should be dollar negative. Inflation risks are heating up. President Joe Biden’s plans to spend several more trillions of dollars on stimulus and infrastructure are sure to push US debt past the US$30 trillion mark.
And vaccine hesitancy is colliding with a Delta variant upending initial successes in getting shots in American arms. But amid all this downward pressure, where is the US dollar? It is up more than 6% against the yen and more than 3% versus the euro in 2021.
The most plausible explanation is that, for all America’s troubles, investors are betting on the reserve currency – on the financial “devil they know.” And at least for the moment, a critical mass of investors has concluded that big stimulus moves take precedence over deficits.
“Overall, we see the shift in positioning sentiment as consistent with the US outspending other countries on the fiscal front,” says economist Robin Brooks at the Institute of International Finance. “That spending should move rate differentials in favor of the dollar over the medium-term.”
Brad Bechtel, global head of foreign exchange at Jefferies, isn’t alone in kicking himself for giving up on bets on a stronger dollar earlier this year. “As someone who was literally the only USD bull in Q4 and Q1 only to turn mildly USD bearish in Q2 … I’m disappointed in myself for not remaining USD bullish,” he says.
The greenback’s defiance of financial gravity is proving to be a blessing and a curse. A blessing? Because a recovering US economy armed with increased purchasing power could be just what export-reliant Asia needs.
A curse? Because, as Harvard University economist Megan Greene notes, the dollar’s key role as invoicing currency means it “pushes down dollar commodity prices, resulting in lower real income and depressed domestic demand for EM commodities exporters.”
Asia’s vulnerabilities
It also makes emerging market dollar debt increasingly difficult to service. Earlier this year, the IIF reported that pandemic rescue moves added about $24 trillion to already record global levels in 2020, pushing IOUs to a record $281 trillion.
Overall, debt-to-gross-domestic-product (GDP) ratios among emerging economies topped 250%, up from 220% in 2019.
“Because economic conditions in the US have improved significantly since last year and there are many signs of inflationary pressures, the situation in some emerging economies could become worrisome,” argues economist Paulina Restrepo-Echavarria at the Fed Bank of St Louis.
If the Fed hits the monetary brakes, she says, “this could spark capital flight from emerging economies to the US and thus depreciate their currencies.”
The question, of course, is whether the reaction to an about-face by the Fed will be of the 2013 variety, or more like 1997.
Much of the attention in recent months has been on a repeat of the 2013 “taper tantrum.” Back then, Morgan Stanley circulated a “fragile five” list that no economy wanted to be on. The finalists back then were India, Indonesia, Brazil, South Africa and Turkey.
This time around, Brooks and his staff at IIF worry more about a “data tantrum.” There’s still a very live risk, he says, of a “string of positive data surprises, as the (US) economy recovered more quickly than expected, pushing longer-term Treasury yields higher.”
Asian Development Bank President Masatsugu Asakawa warns of “potential risks surrounding the debt pile-up.”
As such, risks of a 1997-like pile-up can’t be ignored. The risk is that outflows into the dollar suddenly accelerate, increasing the appeal of the trade and precipitating a capital flight that destabilizes Asia anew.
It’s a risk about which the Bank for International Settlements has been warning since mid-2020. The reason is it was one of the most underappreciated threats during the 2008 global financial crisis.
“After the GFC,” the BIS argues in a recent report, “unexpected dollar appreciation depresses world trade growth, despite making dollar-denominated exports cheaper.” As such, BIS analysts conclude, the dollar’s value is “closely correlated” with the growth of dollar-denominated credit around the globe.
In the years after 2008, the BIS discerned a “negative relationship between dollar strength and growth of dollar credit.”
Because a stronger dollar is often a product of tightening credit conditions, it leaves less cash for banks in the US and beyond to lend to riskier markets. That, in turn, starves developing Asia of capital needed to support currencies and asset markets and repay dollar loans.
1997’s lesson
Asia learned this lesson the hard way. When Thailand devalued the baht in July 1997, it provoked a “flight to quality” trade that sent waves of capital from East to West.
As the weeks ticked by, officials in Jakarta ran out of foreign exchange reserves to stabilize the rupiah. Next, it was Seoul. The flood of dollars rushing out of Asia sent Malaysia to the brink and forced the Philippine government to scramble to save the peso.
The turmoil began shaking Asia’s most developed economies. In November 1997, Yamaichi Securities, one of Japan’s fabled big-four brokerages, collapsed and ceased operations. Attention immediately turned to China. Investors feared what was then Asia’s second-biggest economy might also devalue, kicking off fresh contagion around the globe.
In the wake of that trauma, Asia realized it was too reliant both on the dollar and the US. Efforts to “decouple” from Washington became the economic zeitgeist.
Before long, though, governments pivoted back to US export-led growth. Rather than reduce its US dollar holdings, the region went even bigger on dollar buying. This reserve issue, of course, is among the biggest policy wildcards heading toward 2022.
Last month, think tank Official Monetary and Financial Institutions Forum estimated that a “stunning” 30% of central banks plan to increase yuan exposure in the next one to two years, up from only 10% in 2020.
In a survey of decision-makers at central banks, sovereign wealth vehicles and public pension funds, OMFIF found monetary authorities plan to trim dollars 18% and euros by 16% in favor of the Chinese currency. The most common explanation: favorable rate differentials and growth prospects for China’s $14-plus trillion economy.
Since 2016, if not sooner, Chinese President Xi Jinping has worked to internationalize the yuan. That year, the yuan was added to the International Monetary Fund’s top-five currency basket. Entrance demanded that Beijing submit to steady increases in transparency and convertibility, increasing the yuan’s viability as a leading unit of exchange.
Add in China’s rapidly growing economic scale and a strong desire for de-dollarization among the Persian Gulf states and Russia, and Xi’s team has a good claim to the future. China also is way ahead of other top economies in rolling out a central bank-issued digital currency.
But that is looking ahead. For now, investors are clinging to tried and true safe-haven strategies, like the dollar. So convincing is the long-dollar trade that gold is struggling to maintain recent price highs.
Not that the trajectory is a given, says strategist Margaret Yang at DailyFX. Traders, she notes, are still trying to make sense of signs of softening US data, how the Delta variant affects consumer demand and hawkish comments from Fed officials spooked by a roughly 5% inflation rate.
For Asia, it’s a double-edged sword.
A plunging dollar would be an immediate crisis, sending yields surging and credit spreads blowing out and destabilizing markets everywhere. But a rising US currency is its own challenge to a region that just didn’t see it coming.