A weaker dollar, what the world economy needs

London, October 27

The last thing the world needs right now is a stronger dollar but that’s exactly what it looks like getting.

A rise in the greenback of nearly 20 per cent since summer last year is hurting US exports and slashing corporate earnings there, undermining the world’s biggest economy and one of its twin engines of growth.

In the other, emerging markets, it has contributed to a collapse in commodity prices that has caused economies to stall or shrink while inflating countries’ dollar debt burdens.

Even the Federal Reserve is worried, citing the exchange rate effect on the economy as a factor in its decision last month to delay ‘lift off’ on raising US interest rates. It may play a central role in the Fed’s deliberations this week too.

But as talk of currency wars revives, a weaker dollar is hard to envisage as European and Japanese authorities worried about the effect of their own economies of a rising euro and yen will fight hard to prevent it.

The consensus view among currency market analysts is that the dollar will rise against major crosses over the coming year.

Willem Buiter, chief economist at Citi and a former Bank of England policymaker, says a weaker dollar could help prevent the world economy slipping into a new recession or a prolonged period in which actual growth is far below its potential level.

“The global economy would be helped by faster growth in the United States,” he said. “If that’s brought about by a combined monetary and fiscal stimulus, and done the right way, that would help boost an important source of demand in the world economy.”

That would preclude a depreciation for worrying reasons like a loss of investor confidence in the United States.

With the US economy accounting for a quarter of global output, and the International Monetary Fund (IMF) estimating emerging markets will contribute more than 70 per cent of global growth in the decade to 2020, a weaker dollar could have a powerful stimulative effect.

Research from economists at Deutsche Bank shows that net exports will exert a drag of about 0.7 percentage point on US growth this year, up from the 0.5 they anticipated in January.

The stronger dollar accounts for about 0.5 percentage point of this drag, a phenomenon that will persist beyond this year and peak in the early part of 2016, Deutsche said.

And research by JP Morgan economists into previous episodes where emerging market borrowing has soared shows that growth in these countries always suffers when the debt bubble largely a dollar-borrowing one deflates.

They conclude that emerging market GDP growth could slow to an average of 2.6 per cent in the coming three years from around 5.5 per cent over the last five years.

The effects of dollar strength are already deep and far-reaching.

From IBM to Wal-Mart, the earnings season has shown that the strong dollar is choking corporate America’s profitability. S&P 500 companies’ profits are expected to fall almost four per cent in the quarter.

Emerging market banks and companies that have borrowed huge amounts in dollars are also vulnerable to a stronger greenback.

According to Charlie Robertson at Renaissance Capital, international debt issuance from emerging markets quadrupled in the last 10 years to $2 trillion. Most of that is in dollars.

“A weaker dollar is strongly positive for emerging markets because their external debt burden becomes more manageable and commodity prices tend to do better,” he said.

The emerging markets slowdown is well underway. In January, the World Bank expected developing economies to expand 4.8 per cent this year but it downgraded that assessment in June to 4.4 per cent, citing the dollar as one of its reasons.

While the Fed is mulling when to raise interest rates, European Central Bank President Mario Draghi last week gave a clear nod to further stimulus coming soon and China’s central bank cut interest rates for the sixth time in less than a year.

Barring a coordinated global pact along the lines of past G-7 agreements and joint intervention episodes, it is unclear how a weaker dollar could be engineered, as virtually all the players involved would want their own currencies to weaken.

The Fed could state it will not raise rates for a long time essentially a return to ‘forward guidance’ which would put the dollar on the defensive. But Fed policymakers are unlikely to do this when they’ve come so close to raising rates.

David Bloom, head of FX strategy at HSBC, argues that too much weight is being put on the dollar and that governments, central banks, businesses and consumers will determine global growth trends.

“The bottom line is: currencies cannot save the world,” said Bloom, whose anti-consensus call is for the euro to rise to $1.20 next year.