Tuesday, December 21, 2021

"A Strong Dollar is Threatening the Global Economy"

The dollar index is not all that strong at 96.52 and since November 26 it seems to have found a range between 96.00 and 96.60, so the uptrend appears to have stopped for the last few weeks. The index does not contain the Chinese currency which seems to have stopped gaining strength against the dollar but has not reacted very much to the last two policy moves to weaken it.

The places that can really get hurt by the dollar are the smaller currencies and especially those with even an informal peg to the buck much less a formal one.

From Advisor Perspectives, December 18:

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

The Fed's liquidity fire hose supported the massive government fiscal response to COVID. Through unprecedented asset purchases, the Fed provided enough liquidity to allow the U.S. Treasury to increase its debt burden grossly at historically low yields. Its actions bolstered asset markets and weighed on the dollar in the process.

The Fed is starting to reduce liquidity, and global markets are stirring. The dollar, for one, is on the rise, and with it comes underappreciated consequences.

Most investors know dollar appreciation makes imports cheaper for the U.S. and more expensive for other nations. As such, the dollar affects which countries gain or lose competitive advantages in global trade.

Lesser appreciated, the U.S. dollar is not just America's currency but the world's. Its value versus other currencies significantly affects borrowing costs for foreign entities.

As a result, the Fed dramatically influences global economic activity through its monetary policy.

Unless otherwise noted, all references to the dollar in this article refer to the U.S. dollar.

Background: Dollar hegemony

Before I discuss how the Fed impacts the global economy, it's worth a brief review of the dollar's role in the post-WWII era.

One of our most critical macroeconomic articles is Triffin Warned Us. The article describes the Bretton Wood Agreement of 1944 and Robert Triffin's paradox:

By decree of the Bretton Woods Agreement of 1944, the U.S. dollar supplanted the British Pound and became the global reserve currency. The agreement assured that a large majority of global trade was to occur in U.S. dollars, regardless of whether or not the United States was involved in such trade.

Since 1944, the U.S. suspended the convertibility of dollars to gold, and most countries allow their currencies to float versus the dollar versus remaining fixed. Those were two key tenets of the agreement that no longer exist. While the terms of the agreement may be void, the dollar remains the world's reserve currency. With that, the Federal Reserve is de facto the world's central banker.

As an aside, Robert Triffin recognized the inherent benefits of a global reserve currency but also its "paradox." Triffin argues, the benefits of a reserve currency will create global imbalances and an "inevitable tipping point or failure."

How the dollar affects global liquidity

When a Canadian tire company buys rubber from a Philippine rubber producer, the payment typically occurs in U.S. dollars. Both countries have their own currencies, but neither currency has the liquidity nor the world's largest economy and military power backing it. For these reasons and others, most recipients in foreign trade prefer receiving U.S. dollars.

Because so many foreign countries and companies transact with dollars, they often borrow in dollars and hold dollar reserves. They do this despite the fact their revenue is often not in dollars. It also helps that dollar funding can be cheaper due to greater liquidity in U.S. credit markets.

However, with dollar funding comes dollar risk.

The Loonie Tire Company

Let's consider Loonie Tires, a hypothetical Canadian tire company, and the currency risk it takes when borrowing in dollars. This analysis helps understand why the value of the dollar is such an important determinant of borrowing costs and, therefore a global economic lynchpin.

On June 1, 2021, the Loonie Tire Company borrows $10 million U.S. dollars for one year to purchase rubber. It hopes to sell the tires in Canada for the equivalent of USD 12 million. The interest on the debt is USD 500,000, assuming a 5% interest rate. The transaction should result in a USD 1.5 million or 15% profit assuming no other expenses.

The tire company is borrowing in U.S. dollars, but the sale of tires are in Canadian dollars.

On June 1, 2020, one Canadian dollar bought .83 U.S. dollars. Since then, the value of the Canadian dollar versus the U.S. dollar has depreciated, resulting in an exchange rate of .78 U.S. dollars per Canadian dollar.

The table below compares the transaction's P&L using the initial exchange rate and the current exchange rate.

Loonie's new P&L

Assuming the U.S. dollar/Canadian dollar relationship stays the same, Loonie's expected profits go from 15% to 7.77%. Effectively the cost of borrowing is not 5% as they presumed but nearly 13%. If the loan were to mature today, Loonie would have to pay back almost $800,000 more in principal and $40,000 more in interest than initially expected.

Suppose the future currency exchanges are not hedged, as in our example. In that case, foreign borrowers of U.S. dollars are subject to higher borrowing costs if the dollar rises versus their local currency. Simply the local currency depreciates versus the dollar; therefore, they need more of the local currency to make good on their debt. Because of this construct, a stronger dollar effectively tightens financial conditions on the rest of the world.



 If an exporter such as China can't devalue their currency vis-a-vis their trading partner the only competitive price advantages come from efficiency increases and those have become harder to implement.

Germany, France and the rest of the Eurozone on the other hand, because the euro was floating weaker is looking better and better.

For some of the reasons China can't just devalue 10% or more, say from the current 6.3724 to 7.00 to the buck, see the posts on China's dollar-denominated debt. If interested here is an overview: 

"China is underestimating its US$3 trillion dollar debt and this could trigger a financial crisis, says economist"