Since the start of the year, the Dollar Index, which measures the variation of the US dollar against a basket of six major currencies, including the euro and the British pound, is up 6.8%. The dollar’s appreciation is widespread: 8.2% against the euro and Swiss franc, 9.7% against the British pound and 13.1% against the Japanese yen since January 2022, for example. It is certainly just the beginning. Institutional investors remain en masse long (buyers) on the dollar according to the weekly report published by the United States-based Commodity Futures Trading Commission.
Since the 1980s, the dollar has gone through three cycles comprising both periods of rise and fall: 1980 to the early 1990s (beginning of a cycle of rate hikes under Alan Greenspan), 1995 to 2011 (end of the financial crisis in the United States), and since 2015 (rate hike under Janet Yellen). The culmination of the last cycle, in full swing, has not yet been reached by all logic. We can therefore expect a more pronounced rise in the Dollar Index in the future.
In the space of a few weeks, the number of risk factors has increased, which should ultimately benefit the dollar: war in Ukraine (although the impact is now less), commodities super cycle, constant disruptions in the level of international trade, risk from technical recession in several developed economies (in the UK and, to a lesser extent, in France) and stagflation in others (this is certainly already the case in Germany). In these circumstances, demand for dollars will continue to grow at a time when the US Federal Reserve (through its balance sheet reduction that will begin next month) will begin to drain liquidity. This will also contribute to the appreciation of the dollar to some extent.
We are facing a market where the US dollar remains hegemonic, ultimately with many possible alternatives for operators looking for safe havens. The Swiss franc is not the best option due to the regular interventions of the Swiss National Bank (according to our calculations, almost 4.2 billion francs have been committed in the past two weeks to support the exchange rate of the Swiss currency). Neither is the Japanese yen due to the Bank of Japan’s maintenance of extremely accommodative monetary policy (ultra-low rates and yield curve control), which diminishes the attractiveness of the Japanese currency.
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Another round of dollar appreciation
The appreciation of the US dollar is good news for almost no one. Economics textbooks tell us that a strong dollar has two major consequences: US economic activity slows and US inflation is exported through trade. In a world where all players borrow and bill in dollars, the rise in the dollar has primarily four main consequences: it leads to a decrease in international trade, a decrease in cross-border bank lending, a decrease in capex (corporate investment) and a deterioration of international value chains that have been heavily dependent on the dollar since the 1990s.
A study by Emine Boz (2017) showed that a 1% appreciation of the US dollar reduces internationally traded volumes by an average of 0.6-0.8% over a year. Since the dollar’s gains will certainly be in the neighborhood of at least 4% this year, it will lead to a drop in traded volumes of at least 2.4% in one year. It’s huge. This means less global growth and an even more unequal distribution of wealth (as the United States remains the big winners due to the strong dollar).
In this context, emerging countries are the most vulnerable. A study by the Bank of England shows that a 10% increase in the US dollar leads to an average 1.5 percentage point drop in emerging countries’ GDP. At present, no comparable research has been conducted in developed countries. We can simply assume that the impact is less, due to a lower reliance on dollar funding.
Alternative solutions that are not credible
A diversification of the international monetary system, which is currently dominated by the dollar, has not yet been an optimal solution. However, there are many initiatives. India, for example, is studying a rupee oil-swap mechanism to import Russian oil (thus evading US and EU sanctions). However, the impact remains small.
With each new crisis, there is plenty of demand for an alternative to the US dollar. But neither the euro, nor the renminbi, nor the bitcoin can replace the dollar. Weaknesses in the institutional architecture of the euro prevent a mass adoption (this entails risks of monetary fragmentation between Member States, as was the case in 2012). The renminbi is insufficiently internationalized (it is not freely convertible) and recent events in China surrounding the fight against Covid call for caution with regard to Beijing’s openness policy. Finally, Bitcoin has all the hallmarks of a risky asset, evolving along with the US technology index Nasdaq. It is by no means a credible store of value in times of risk aversion. We remain in a world centered on the US dollar. The dollar currently makes up 70% of foreign exchange reserves. It’s huge. We can certainly regret that. But there is no better solution than to live with it.
It is up to the central banks of other countries to defend their currencies. Some have done so with undeniable success, often aided by rising commodity prices (for example, the Central Bank of Brazil). Others are doing it with more mixed success (European Central Bank, to name a few). The risk is that this defense of currency will lead to what we experienced in 2011: a currency war.
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