Dollar strength poses challenges to global growth

The rising dollar has become a key theme in global financial markets and a matter of concern, especially for emerging economies.

A recent Bank for International Settlements (BIS) study shows that an increase of 1 percentage point in the value of the US dollar can dampen the growth outlook of emerging market economies by more than 0.3 per cent.

Although currency movements have always been complicated both in their causes and consequences, this time around the dollar’s strength is largely driven by the rising US interest rates driving capital flows out of emerging economies.

Currency volatility

Emerging market currencies are inherently more volatile and are regularly buffeted by external shocks and or political, economic, and market forces. Undoubtedly, the strengthening of dollar is playing havoc with exchange rates of their currencies and debts.

The current rise in the dollar is largely driven by US interest rate hike and the guidance of further hikes this year. US Federal Reserve held interest rates near zero following the pandemic prompting vast capital flows into emerging markets.

Clearly, a strong dollar is changing the global investors’ risk-reward sentiment towards emerging markets, leading to sharp currency depreciations fuelled by massive sell-offs and capital outflows in a flight to quality. Capital outflows from these countries are likely to weigh on their economic growth.

A weak currency need not be always bad for an economy as it make exports cheaper. However, its impact on inflation and debt burden can be debilitating, especially for economies that are short of capital.

Pressure on peg

Although a rising dollar comes with some benefits in terms of lower imported inflation for consumers in the US and those countries with pegged currencies, like the GCC, the overall long term impact of a rising dollar on these economies can be negative.

A strong dollar translates into appreciation in the real effective exchange rates [weighted average of a country’s currency in relation to a basket of other major currencies] of dollar pegged currencies, making exports costly and imports cheaper that could effectively slow down economic diversification.

Despite the currency stability the dollar peg brings, the event of extreme volatility of dollar against other major global currencies could raise questions about the efficacy of the peg in supporting GCC’s long term non-oil economic prospects.