This article first appeared in The Edge Malaysia Weekly on May 23, 2022 - May 29, 2022

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While this is not the first time “a perfect storm” has been used to describe the challenging environment, economists and analysts contacted by The Edge say that the “storms” of the past do not compare with the one brewing now.

In a nutshell, we are talking about the strong US dollar and its impact on the global economy at a time when inflation has been pushed higher the world over with commodity prices — from wheat and coal to metal, crude oil and crude palm oil — surging on the back of supply chain disruptions caused by the Covid-19 pandemic, compounded by the Russian invasion of Ukraine.

The US dollar has been strengthening over the last couple of months since the Federal Reserve raised the Fed funds rate by 25 basis points (bps) at its March 2022 meeting to tame inflation in the world’s largest economy.

The US Dollar Index (DXY), which tracks the movements of the greenback against a basket of major currencies including the pound sterling, euro, yen, Swiss franc and Canadian dollar, was hovering around 96 points in December 2021. At the time, talk of rate normalisation by the Fed was already underway as inflation swung to the highest level in more than 30 years in the US.

The index, which started in 1973 after the collapse of the Bretton Woods standard that saw the US dollar no longer backed by the Fed’s gold reserves, went on to breach 100 points in the middle of April following the first interest rate hike a month earlier.

By the middle of this month, the DXY had pushed towards 105 points, a level not seen since late 2002. It was still hovering near 103 at the time of writing. In short, the US dollar today is at its strongest in 20 years and this could have a fundamental, although temporary, impact on the global economy.

“The prevailing condition becomes highly uncertain when talk of a possible 50bps increment at one go had gained further strength and true enough, the Fed did raise the benchmark interest rate by that much in early May. Thereafter, the market sentiments have become fixated on a Fed that is likely to be hawkish throughout the year,” Dr Mohd Afzanizam Abdul Rashid, chief economist at Bank Islam Malaysia Bhd, tells The Edge in an email.

The 50bps hike earlier this month was the first time the Fed had done so in 22 years, as a result of persistently high inflation going back to the second half of 2021.

In 2021, the average consumer price inflation in the US was 4.7%, the highest since 1990. Inflation in January this year was at 7.5% year on year (y-o-y), followed by 7.9% in February and 8.5% in March, and remained stubbornly high at 8.3% in April.

While most economists agree that the Fed funds rate should be raised to fight inflation and that rate normalisation should happen with inflation in the US at its highest in more than 30 years, talk of a 50bps or even 75bps hike over a short period has impacted the global market.

Some observers have drawn parallels with 1994 when the Fed, under then chairman Alan Greenspan, nearly doubled interest rates to 6% in seven hikes, including two 50bps increases and three 25bps hikes, within a span of 12 months.

Investors have flocked to US-dollar assets on expectations of a very hawkish Fed.

The 10-year US Treasury yield has been increasing this year, pushing towards the psychological level of 3% in April 2022. This makes US Treasury bills much more attractive to investors worldwide, which puts much more pressure on other currencies against the US dollar.

“As the US monetary policy is a major driver of the global financial cycle and cycles of capital flow, the quantum of the Fed funds rate increases and the degree to which the Fed surprises the market may pose dangers to emerging market economies (EMEs),” says Lee Heng Guie, executive director of the Associated Chinese Chambers of Commerce and Industry of Malaysia’s Socio-Economic Research Centre (SERC).

Past experience shows that the rise in US interest rates, driven by expectations of more hawkish monetary actions, is a reliable predictor of financial stresses in EMEs. These episodes were demonstrated in the Latin American crises of the early 1980s, the Mexican crisis in 1994 and the US taper tantrum in 2013 that led to huge outflows of funds from EMEs.

According to Lee, the International Monetary Fund’s (IMF) study on monetary policy surprises by the Fed or the European Central Bank (ECB) indicated that each percentage point rise in US interest rates tends to immediately lift long-term interest rates by a third of a percentage point in the average EME, or two-thirds of a percentage point in an economy with a lower, speculative-grade credit rating.

“The increasing US interest rates [currently] happen at a time when EMEs are being significantly challenged by a multitude of shocks, from persistent supply disruptions to rising cost and inflation pressures, weaker local currencies and negative shocks from the Russia-Ukraine war,” says Lee.

The increase in US interest rates tends to push up the value of the US dollar and this makes it difficult for EMEs on three fronts — borrowing costs, capital flows and exchange rates.

The rising US dollar leads to an increase in the real value of dollar-denominated debt, increasing the cost of servicing those debts in the local currency. Higher interest rates and tighter liquidity conditions also limit and make it costly for the government and companies to borrow or refinance debt under sustainable conditions.

Higher interest rates in the US could also result in capital moving away from EMEs and flowing into US Treasury securities in search of higher investment returns. These also typically support the US dollar by making dollar-denominated assets more attractive to yield-seeking investors, which means EME currencies will come under a lot of pressure.

However, surely not all EMEs are the same and will face similar challenges and opportunities in the light of a strong US dollar.

According to Lee, the degree of generated adverse spillovers to EMEs would depend on their state of economic and financial resilience, including their economic prospects and inflation outlook, fiscal and debt sustainability, the health of their current account position and foreign reserves accumulation.

“EMEs with ample monetary and fiscal space, strong recovery prospects, well-anchored inflation, manageable fiscal and debt levels, healthy current account balances and a strong war chest of unencumbered foreign reserves have been able to withstand interest rate increases in advanced economies,” he says.

“However, the Covid-19 pandemic shock has weakened some countries’ lines of defence against future shocks. Some have narrowed fiscal space and are laden with bloated government and corporate debt.”

Countries that have foreign reserves that can retain imports between 3½ and 4 months, as well as cover 100% of short-term external debt, could withstand the effect of a strong US dollar better than countries that have lower metrics.

According to the Institute of International Finance (IIF), the global debt-to-GDP ratio surged by 35 percentage points (pps) to more than 355% of GDP in 2020. The upswing was well beyond the rise seen during the 2008 global financial crisis, the institute states in a report.

Back in 2008/09, the increase in the global debt ratio was limited to 10pps and 15pps respectively. In 2021, global debt surpassed US$300 trillion, according to IIF.

Among selected EMEs in Asia-Pacific, Indonesia has the most exposure to US dollar-denominated debt as at 4Q2020, at 7.9% of GDP, according to the IIF. However, the country has relatively low total government debt-to-GDP, which stood at 39.1% of GDP in 4Q2020.

In comparison, India’s total government debt-to-GDP in 4Q2020 was 89.1% of GDP, of which dollar-denominated debt amounted to 3.2% of GDP. Its neighbour China had a total government debt-to-GDP of 65% in 4Q2020, but dollar-denominated debt amounted to only 0.7% of its GDP.

According to IIF, Malaysia’s government debt-to-GDP stood at 63.5% of GDP in 4Q2020, but its US dollar-denominated debt was small at about 2% of the country’s GDP.

European EMEs were more exposed to US dollar-denominated debt as at 4Q2020, according to IIF data. Ukraine, which is currently embroiled in a military conflict with Russia, has foreign debts denominated in the US dollar amounting to the equivalent of 28% of its GDP.

Turkey is another country with huge exposure to US dollar-denominated debt. In 4Q2020, the country’s foreign debts denominated in the US dollar amounted to 16.5% of the country’s GDP. Hungary’s dollar-denominated debt was equivalent to 6.2% of its GDP in 4Q2020.

However, among the EMEs, none is more exposed to the strong US dollar than Argentina. The South American nation’s dollar-denominated debt was equivalent to 53.5% of its GDP in 4Q2020. This means Argentina, a country that has a long history of sovereign defaults, could risk yet another if the US dollar continues its ascendancy and the global economic recovery falters.

Last Wednesday, Sri Lanka, which is struggling with fuel and food shortages amid political turmoil, defaulted on its debts for the first time in its history. According to the most recent data provided by the Sri Lankan Department of External Resources, as at 2019, the country had US$64.6 billion of dollar-denominated debt. Given that Sri Lanka’s GDP in 2019 stood at US$83.98 billion, this translates into dollar-denominated debt that amounts to 77% of the country’s GDP.

“Emerging markets that have more import demands will suffer greater. This will increase the price of the importing commodity, which later translates into pricing in the country. As a result, the purchasing power of the people will be compromised to a certain extent, impossible to purchase and consume,” says Dr Zokhri Idris of the Institute for Democracy and Economic Affairs (IDEAS) Malaysia.

Bank Negara Malaysia, he says, has predicted that Malaysian goods and services will be more competitive due to the depreciation of the ringgit against the US dollar. While this is true in theory, Zokhri opines that the country needs to critically evaluate the demand of other economies for Malaysian goods.

“This [Malaysian goods and services to be more competitive] could be the case for petroleum and natural resources such as palm oil. However, the purchasing power of the [trading partner] economies also need to be considered, whether or not their local currency is able to be balanced should they trade with Malaysia,” he says.

If the weak ringgit could make Malaysian exports more competitive, so will the exports of other countries whose currencies also depreciated against the greenback.

Malaysia has experienced several episodes of large and volatile capital flow reversals. For example, during the 2008 global financial crisis, the country saw portfolio outflows of US$26 billion between the third quarter of 2008 and the first quarter of 2009, says SERC’s Lee.

The country also saw US$13.7 billion in portfolio outflows between the third quarter of 2014 and third quarter of 2015 during the oil price shock, he adds.

Many central bankers around the world have reacted to the strong US dollar and global inflationary pressures by raising their interest rates.

Last Thursday, the Central Bank of Egypt raised its overnight interest rates by 200bps to 11.25% for its deposit rate and 12.25% for its lending rate as it seeks to contain inflation expectations that had surged to 13.1% in April — the highest since May 2019.

The Reserve Bank of South Africa raised its benchmark interest rate by the biggest margin in more than six years, with a 50bps increase in the repurchase rate to 4.75% last Thursday.

Meanwhile, Bangko Sentral ng Pilipinas raised its key interest rate for the first time since 2018 by 25bps to 2.25% last Thursday to combat inflation. Bank Negara raised its overnight policy rate by 25bps to 2% on May 11.

While raising interest rates could provide short-term relief to price and currency stability, long-term solutions such as reducing structural fiscal deficits, reducing debt and liabilities and rebuilding the fiscal buffer against future shocks are still needed, say economists.

To be clear, the strong US dollar outlook is not just about the Fed raising its interest rates. The slowing global growth cycle is another key source of US dollar strength, according to HSBC Global Research.

That is because the US dollar is a counter-cyclical currency and when the global economy loses momentum, the greenback tends to perform better and vice versa, the research arm of the London-based banking group says in a recent report.

“As global growth peaked sequentially in mid-2021, it marked the start of the US dollar’s upward trend and there are few signs that this factor is going to turn for the better.”

With the downside risk with ongoing uncertainties from the Russia-Ukraine war, high commodity prices and the associated squeezes on real incomes and consumption, “we think the US dollar should continue to benefit”, it adds.

Another important factor to be considered on how long the strong US dollar will continue is the actions of China. The global supply disruption has persisted but the slowdown in China has been another source of concern as it is the world’s largest exporter and importer, says HSBC Global Research.

With Covid-19 proving challenging on the China mainland, domestic production has been impacted by labour shortages and transport difficulties, contributing to the relatively quick renminbi (RMB) weakness lately, it adds.

“While we do not believe the [Chinese] authorities are purposely weakening the RMB, it is a source of broad USD strength. However, if China eventually shores up its economy with stronger stimuli, then this should help currencies that are sensitive to the respective growth outlook and the RMB,” it continues.

“The near-term uncertainties are high but if RMB weakness slows, as we expect, this should provide room for positive idiosyncratic stories to play out for certain Asian and Latin American currencies later on.”

With the Fed still sounding hawkish and global growth risks skewed to the downside, HSBC Global Research forecasts a continued strong US dollar environment. While there has been consistent pushback against the strength of the greenback, on the grounds that it is overvalued, it is not yet a significant constraint in the banking group’s view.

An acceleration of global growth and a big about-turn by the Fed would likely be needed for the US dollar to start reversing its recent gains, explains HSBC Global Research.

“China also matters a lot for our broad US dollar thinking. If we are correct that strong stimuli will emerge eventually in China, this should mitigate some of the strong US dollar forces. If we are wrong, then the US dollar’s strength could be more pronounced and destructive than many, including us, expect,” says HSBC Global Research.

In a world where US consumers have been one of the key supports of global recovery in the last few quarters, if consumption growth slows as the Fed’s monetary policy tightening slowly takes hold in the world’s largest economy, there may be further downside risk to global growth dynamics.

“For us to turn more cautious on US dollar, we would need to expect global growth to trough and accelerate. Indeed, earlier this year, there were hopes that global supply chain pressures would moderate and the trade/manufacturing cycle could strengthen,” says HSBC Global Research.

“If this had materialised, it would have caused headwinds for US dollar. However, this has not happened and we see few reasons to believe the bottlenecks for growth can improve much in the months ahead.”

Whether or not the US dollar continues to strengthen, policymakers must not allow it to derail the post-Covid-19 economic recovery. There is already too much catching up to do post-pandemic.

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