Appreciation in the greenback creates political and economic problems
Mohamed El-Erian
For some, a strong dollar is part of an orderly rebalancing of the global economy © Denisfilm/Dreamstime
The recent strength of the US dollar has triggered two very different reactions among economists and market participants.
Some see it as contributing to better global economic performance down the road. Others fear that it will create disruption.
Both cannot be right.
The answer is likely to be determined by politics rather than economics — specifically, manoeuvring in the run-up to next year’s US elections.
Investors and companies can take actions now to partially protect themselves from disruption.
Such evasive manoeuvres are warranted given the higher probabilities for more extreme outcomes in a range of areas.
Sustained dollar strength is not a surprise given three major factors pulling foreign capital into the US: a domestic economy that has consistently outperformed other advanced countries, a stock market that has outpaced others and, for fixed income investors, an unhedged yield advantage.
Investors believe that, in today’s weakening global economic environment, only America is able to sustain a prolonged appreciation in its currency. European and emerging economies fear that any persistent strengthening of their currencies would further slow their growth. This also explains the contrasting views as to what comes next.
For some, a strong dollar is part of an orderly rebalancing of the global economy. By boosting weaker economies that are more open to trade and that have suffered more from the global trade war, it helps them to catch up with the outperforming US.
But the strong dollar poses risks. First, it threatens a currency war on top of the protracted trade war — fuelled by the Trump administration’s efforts to undo what it views as unfair trade practices against the US.
Second, it exposes the Federal Reserve to further political attacks, undermining its credibility and the market confidence that comes with that.
Third, it can destabilise emerging markets with large currency mismatches, including what economists call the “original sin”. This is where countries have borrowed heavily in dollars but generate the bulk of the income used for interest and maturity payments in currencies that depreciate relative to the dollar.
All three factors weaken growth, increase market volatility and tighten financial conditions. They would come at a tough time for the global economy. Global economic activity and trade are decelerating, Europe could fall into economic recession next year, central banks are running low on policy ammunition, and there are few, if any, inspiring emerging-market reform stories.
What transpires will depend, first and foremost, on US politics — tilting probabilities in favour of the more disorderly outcome. Levelling the international playing field on trade, particularly with China but also with other countries, is one of the few issues that commands quite broad political support in America.
Not all agree on the methods, but most are united in pursuing better trade terms for the US.
This increases the likelihood of the weaponisation of currency policy.
Europe and China can counter this risk, albeit only partially, by making more timely concessions to the US, especially when it comes to longstanding grievances, such as intellectual property theft and forced technology transfers to China.
As part of a rebalancing of policies in favour of structural reforms and fiscal stimulus, the European Central Bank could also help by gradually moving away from its liberal use of unconventional monetary policy to influence asset markets. This has been a disappointing pursuit of better economic outcomes overall, and is becoming increasingly counter-productive.
The binary outcome associated with dollar strength is an example of a phenomenon that is playing out not only in economics and finance but also institutionally, politically and socially.
That is a declining probability for the continuation of status quo, and higher probabilities for
more extreme outcomes on either side of the status quo.
This phenomenon is gaining greater recognition, but not as much as it deserves. That is not surprising, perhaps, given that there are many behavioural reasons why we resist being taken out of our comfort zones.
In this age of extremes, what can companies and investors do?
They can reduce currency mismatches, increase their cash buffers and search for cost-effective hedges in order to bolster resilience.
In their fixed income activities, investors could also move up in quality and shorten maturities in order to limit exposure to extreme outcomes while retaining some upside.
And for US companies with operations abroad, they should narrow their focus to meeting demands there rather than also sourcing in size for the home market — the “in China, just for China” strategy.
Competing claims about the implications of a strong dollar is but one of a lengthening list of unusual uncertainties facing today’s fragile global economy.
Rather than ignoring the higher probability of extreme outcomes, companies and investors and companies need to confront it in their strategic planning. Think of it as minimising future regret.
Mohamed El-Erian is Allianz’s chief economic adviser and president-elect of Queens’ College, University of Cambridge
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