USD going up, up and away

Exchange rates most often impinge on the economic world when there’s big drama — China’s surprise devaluation in 2015, the crisis of confidence with EUR in 2000, the Asian currency collapses of 1997. There’s a sleeper hit developing right now with the dollar.

The Bloomberg Dollar Index, which measures the greenback against a basket of other major currencies, is heading for its biggest monthly gain since March 2020 — when global markets were in turmoil over the eruption of the pandemic and there was massive emergency demand for dollars.

On the flipside, the currencies of countries including Chile, Poland, South Africa and Turkey have tumbled in double-digit percent terms over the past six months.

USD is appreciating as investors start building in a more aggressive withdrawal of Federal Reserve monetary stimulus. San Francisco Fed President Mary Daly said on Wednesday that she’d support a faster taper if data stay strong. Some Wall Street banks raised forecasts for economic growth in the fourth quarter after a wave of robust data was released.

A rising USD would have significant consequences in particular for emerging markets, which still rely to a large extent on it for their borrowing needs. The stronger the currency is, the more expensive it is for companies and governments in developing nations to make payments on debt denominated in greenbacks.

Even as the American share of the global economy has declined over the years, the role of the dollar has in many ways strengthened — increasing the consequences of its appreciation. A Bank for International Settlements report in September showed that outstanding dollar credit to companies and other non-bank borrowers outside the US more than doubled since the financial crisis in 2008 to US$13 trillion by the end of March.

A host of emerging and developing central banks — from Chile to Russia to Pakistan — have already started increasing interest rates well ahead of counterparts in the developed world, and the prospect of their currencies weakening against the USD will only add to the pressure to extend or even strengthen those campaigns.

As the Fed moves to curtail the supply of USD, by winding down its quantitative easing program and turning at some point toward raising interest rates, conditions will only get tougher for emerging-nation borrowers. That will add further headwinds for economies struggling to match the rich nations in combating the pandemic.

“The peak in terms of the flow of liquidity’’ in USD “is behind us,” Shweta Sing, a managing director at research firm TS Lombard, wrote in a report. The big build-up in the Fed’s balance sheet since early 2020 has “meaningfully mitigated the ripple effects from a strong USD to global financing conditions,” she said. “But the risks are building up.”