Why A Strong Dollar Is Bad for Emerging Economies

What Does Currency Strength Actuall...
What Does Currency Strength Actually Mean?

Since the beginning of this year, the US dollar (USD) has been constantly increasing in strength and has even been able to rub shoulders with the Euro in value for the first time in so many years.

To the US, a strong USD is a blessing, but an economic problem for countries that depend on imports, especially from the US market.

Such imports into emerging markets will indirectly turn to inflation and may impact the rising prices of goods and services.

It is necessary to start by highlighting the fact that many times, as the US dollar is appreciating, several other currencies keep depreciating against it.

For some countries that have competitive currencies in the global market with measures in place to curtail the effects of a stronger US Dollar, this is not a big deal because it won’t have severe consequences on their economy.

The case isn’t the same for emerging economies that depend on loans from the World Bank and the International Monetary Organization (IMF) or any other US-based credit-financing bodies.

They pay back their debts in USD, meaning a strong US dollar would force them to pay more and could wreak havoc on their economic profile and spiral into an economic crisis if it is not well managed.

What are the effects of a strong USD on emerging economies?

Emerging economies in this context refer to economies that are easily exposed to an economic shake-up in the global market.

They are rapidly growing and volatile economies that are found in parts of Asia, Africa, and part of South American countries. They also include developing countries.

So, It is, therefore, necessary to explore certain core effects of a strong dollar on emerging markets.

High Demand for US-Dominated Investment

A lot of factors could be responsible for the dollar to keep rising against its competitors and emerging markets.

For instance, the invasion of Ukraine by Russia has significantly triggered a high demand for the US dollar.

Because of the war, many investors are taking their resources out of Europe and are looking towards a safer USA, triggering an increase in global investments in US-denominated assets.

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The implication of this, as expected, is that more investors keep seeking to buy more dollars for these investments.

Even before the issues in Europe escalated, the US dollar witnessed an instant appreciation as soon as the invasion of Ukraine started.

Historically speaking, this is not a new phenomenon, particularly as we consider the fact that these have been the usual trend whenever there is a global concern in certain parts of the world.

Concerns about Debt

Immediately after COVID-19, many emerging economies were unable to meet their economic obligations like providing essential services to their citizenry.

The impact of the pandemic on emerging economies was unimaginable, some of them are still struggling to recover.

They ran to the World Bank and IMF to borrow and take more loans on top of their existing disappointing debt profile.

Lenders are only eager to lend to developing countries with a stronger currency like the US dollar, and not in their own weak and volatile currencies.

These countries usually agree to pay back their debts in dollars too, irrespective of what the exchange rate is.

This is one of the core effects and burdens which a stronger dollar pushes emerging economies into.

As the dollar strengthens, when it’s time to repay its debts, it becomes more expensive in terms of the domestic currency.

Sometimes, some of the emerging economies used their natural resources as collateral in case of default.

For instance, the debt profile of Africa’s largest economy continues to rise between 2015 to 2022 to USD103.31 billion or NGN42.84 trillion as at June 30, 2022, according to the Debt Management Office of Nigeria (DMO).

Because of the rising demand for US dollar within Nigeria, the Central Bank of Nigeria has had to devalue the naira several times while importers resorted to the parallel market rate aka black market rate whenever the CBN can’t meet their demand for USD.

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Spiral Hike in Interest Rate

The United States government wilds so much power that whenever its Federal Reserve raises interest rates, it affects the economies of many countries around the world.

No wonder several other apex banks around the world are ‘forced’ to jack up their interest rates too.

This is important for them if they are to remain competitive and effective in defending their currency.

In other words, investors must be given a reason (higher returns) to invest in an EM rather than move their money into less-risky US assets.  

So, many times, the central banks of developing countries struggle with the stability of their economies.

For instance, in November 2022, the Federal Reserves raised its interest rate which is now between 3.75% to 4.25%

The US Federal Reserve’s action triggered countries like Ghana to raise its rate by 250 bps to 24.5% during its October 2022 meeting, according to Trading Economics.

In Nigeria, the CBN raised interest three times as of October 2022. It latest at the time of publication is 15.5% from 14%.

 As of November 1, 2022, 6.25% is the interest rate by South Africa. Interest rate adjustment is common whenever the United States does.

They tend to commit themselves to secure foreign investment in the domestic economy, but we can’t ignore the fact that hiking rates will jack up the cost of domestic borrowing and also have a devastating effect on growth.

Therefore, in the middle of all of these, foreign investors keep pulling their resources out of emerging markets.

According to reports, massive funds have been pulled from emerging markets in the past five months alone, as these foreign investors are concerned about the safety of their investments.

For a stabilized economy, hiking interest rates is one of the effective ways to fight inflation, but for an economy that majorly depends on imports, it may further compound their economic woes.

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Spike in Inflation

As the dollar strengthens, its impact is felt on trade in the global market. USD is the most south-after global currency.

Even organizations doing business in other parts of the world are making use of the currency to engage in trade.

We should, for instance, consider a global and essential commodity like oil that is traded with the US dollar.

We can’t also ignore the fact that several developing economies are weak on the global scale, as their actions don’t really make a massive impact in global markets.

As a matter of fact, they are usually at the receiving end and are the ones at the mercy of whatever is happening on the global scene.

Therefore, a strong dollar can determine a lot on their economy, even domestically. For instance, several times, it leads to increase in the price of goods in the local market.

Therefore, as the dollar is increasing in value, imports get expensive, and the implication of this is that businesses will likely reduce investments in the short term.

Of course, we can’t ignore the fact that all of these will have a mild effect on export-led economies. Those in this category will be positioned to benefit as increased exports boost GDP growth as well as foreign reserves. Unfortunately, many developing economies are import-led ones.

Solution:

Historically, there will always be factors that will keep jacking up the value of the US dollar, and there will always be an ugly effect on emerging markets.

Solutions to help ease the pain when such situations arise are not merely short-term. Rather, the government of such countries must heighten their exports to increase the value of their local currency, and earn more in dollars.

They must only engage in sustainable borrowing. Emerging economies must avoid taking loans to finance loans.

A strong US dollar is bad for an economy that produces nearly nothing other than imports.

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