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<\/div>\nThe US dollar is on a tear, strengthening around 11% since the start of the year and \u2013 for the first time in two decades\u202f\u2013 reaching parity with the Euro.\u00a0<\/p>\n
Indeed, an overwhelming number of major currencies have depreciated against the dollar, with big implications for the developing world. <\/p>\n
Given the slew of headlines, I wanted to outline some of the key impacts that a strong dollar has on emerging markets (EMs).\u00a0<\/p>\n
First, why is the dollar appreciating?\u00a0\u00a0\u00a0<\/strong><\/p>\n <\/p>\n The dollar is strengthening primarily because there is strong demand for dollars. The\u00a0economic outlook\u00a0for most economies points towards a major slowdown.<\/p>\n Meanwhile, the war in Ukraine has created massive geopolitical risk and volatility in markets.\u00a0 On top of that, historic inflation has prompted the US Federal Reserve to aggressively hike rates.\u00a0<\/p>\n These factors, among others, are prompting a flight to safety, wherein investors are exiting positions in Europe, EMs, and elsewhere and looking for safe harbour in US-denominated assets \u2013 which, obviously, require dollars to buy.\u00a0<\/p>\n This is not a new phenomenon. The invasion of Ukraine has triggered an initial appreciation of the U.S. dollar against EM currencies that was larger than appreciations related to the\u00a02013 taper tantrum\u00a0and previous conflict-related events involving oil exporters.\u00a0<\/p>\n The market continues to expect rapid Fed rate increases. In similar situations of rapid rate increases in the past, EMs have faced crises. This was the case in the 1980s in Latin America with the \u201cLost Decade,\u201d and in the 1990s \u201cTequila\u201d crisis in Mexico (which then extended to Russia and East Asia). If you\u2019re interested in the debt risks associated with stagflation,\u00a0check out the latest World Bank Development Podcast.\u00a0<\/p>\n Debt Worries\u00a0<\/strong><\/p>\n So, building on that, expect to see more stress in the sovereign debt space \u2013\u202fwhich is already troubled.\u00a0\u00a0<\/p>\n Many countries \u2013\u202fespecially the poorest \u2013\u202fcannot borrow in their own currency in the amount or the maturities they desire. Lenders are unwilling to assume the risk of being paid back in these borrowers\u2019 volatile currencies. Instead, these countries usually borrow in dollars, promising to repay their debts in dollars \u2013 no matter the exchange rate. Thus, as the dollar becomes stronger relative to other currencies, these repayments become much more expensive in terms of domestic currency. This is what \u2013 in public debt lingo \u2013 is called the \u201coriginal sin\u201d.\u00a0<\/p>\n So, who is better off? The share of dollar-denominated debt is relatively low among East Asian countries, and Brazil has fared pretty well in recent months. The latter has benefitted from the central bank\u2019s large dollar holdings, the fact that the private sector seems to have insulated itself well against currency fluctuations, and that it is a net commodity exporter.\u00a0<\/p>\n Growth Concerns<\/strong>\u00a0<\/p>\n As the US Federal Reserve hikes interest rates, other central banks must raise their own rates to remain competitive and defend their currency. In other words,\u00a0investors must be given a reason (higher returns) to invest in an EM rather than move their money into less-risky US assets.\u00a0\u00a0<\/p>\n This presents a conundrum.\u00a0On one hand, a central bank obviously wants to protect foreign investment in the domestic economy. But, on the other hand, rate hikes increase the cost of domestic borrowing and have a dampening effect on growth as well.\u00a0\u00a0<\/p>\n The Financial Times, citing data from the Institute of International Finance,\u00a0recently reported\u00a0that, \u201cforeign investors have pulled funds out of emerging markets for five straight months in the longest streak of withdrawals on record.\u201d This is crucial investment capital that is flying out of EMs towards safety.\u00a0<\/p>\n Finally, a domestic slowdown will, in time, hit government revenues and could thus exacerbate aforementioned debt problems.\u00a0<\/p>\n Trade Troubles<\/strong>\u00a0<\/p>\n In the short term, a strong dollar can also weigh on trade.\u00a0 The greenback dominates international transactions. Firms operating in non-dollar economies use it to quote and settle trades.\u00a0 Just look at key commodities like oil, which are bought and sold in dollars.\u00a0<\/p>\n In addition, many developing economies are price-takers (their policies and actions don\u2019t impact global markets) and are largely dependent on global trade; a strong dollar can have major impacts on them, domestically, including spiking inflation.\u00a0<\/p>\n As the dollar strengthens\u202fimports become expensive (in domestic currency terms), thus forcing firms to reduce their investments or spend more on crucial imports.\u00a0<\/p>\n The long-term trade picture is rosier for some, but overall it\u2019s an uneven picture.\u00a0 Yes, imports are more expensive amid a strong dollar, but exports are relatively cheaper for foreign buyers.<\/p>\n \u00a0 Export-led economies may be able to benefit as increased exports boost GDP growth and foreign reserves, which helps to alleviate many of the issues detailed here.\u00a0<\/p>\n Easing the Pain\u00a0<\/strong><\/p>\n Unfortunately, countries have few options to address these problems in the short term. These issues are best dealt with pre-emptively rather than reactively.\u00a0<\/p>\n