Where Next for the U.S. Dollar?

Introduction.

The COVID-19 pandemic has rattled financial markets, caused a protracted slowdown in the global economy, and accelerated structural trends such as digitization, automation, and aging demographics across advanced economies. As the pandemic ravaged through economies, it equally caused a broad-based decline in currencies across developing and emerging market economies. This depreciation was driven by deteriorating global conditions, lower external demand, and weaker oil prices. This was accentuated by a stronger dollar, which appreciated after its haven properties were triggered and a surge of inflows into the U.S; treasury’s provided support for the “greenback”.

A case is the Franc CFA, a currency pegged to the Euro which is the main instrument of exchange in the CEMAC region. This includes Cameroon, Chad, the Central African Republic, and Congo. Rep, Equatorial Guinea, and Gabon. The chart below provides an illustration of developments in the CFAF, which waxed and following the COVID-19 pandemic.

Figure 1: Taux de change, Dollar américain contre Francs

Source: Institut Nationale de la Statistique

Source: Cameroon, Portail de Donées

In February, the CFAF depreciated 1.8% to 601, 603.65 in April, and 601.71 in May. The dollar-driven depreciation in the exchange rate was equally driven by weaker oil prices. In the first half of 2020, the Chinese Renminbi, the Indian Rupee, the South African rand, and the Turkish Lira depreciated due to border closures, lower exports and restrictions impose don’t eh economy due to the pandemic. However, much of the dollar appreciation has reversed in recent months as fiscal stimulus across emerging markets and lockdown measures have provided support to the economy. A range of financial measures including wage subsidies, loan guarantees, and grants kept businesses afloat and the recovery in external demand and partial reopening of the economy across advanced economies put downward pressure on the dollar.

One can expatiate on monetary, financial, and non-financial drivers, but it is important to make a distinction between short and long-term drivers. In Project Syndicate, a recent interview with Prof. Nouriel Roubini was instructive. In it, he points out that short-term drivers such as the dollar’s haven properties will likely provide upward momentum to the greenback. This is true as illustrated in the case of the Franc CFA, the currency used by the CEMAC region. During periods of macroeconomic uncertainty such as the now, capital tends to flow into dollar-denominated assets as investors hedge against global uncertainty and reverse the global search for yield. In the short run, the dollar is bound to appreciate as a vaccine becomes widely available and economic activity resumes.

However, other factors will prevent a protracted appreciation, as its huge fiscal deficit and public debt will prevent any exaggerated optimism regarding its prospects. On the one hand, this will prove a boon for global trade, which is inversely related to the dollar. In 2019, I opined about this relationship and showed how a stronger dollar hurt global trade and increased the structural deficit in emerging and developing market economies. This will place a floor on emerging market currencies, enabling them to benefit from a post-COVID renewed optimism driven in part by a reopening of borders. The long-term drivers of the dollar are significant and do not always because of a persistent appreciation as one would expect. However, its role in global trade and capital markets will equally provide some upward support. It is not clear that is sufficient to improve the dollar’s prospects, but the transience of its global dominance a recurrent feature that will likely prevent a marked decline.

Secondly, the rise of the Renminbi is another feature that could place downward pressure on the dollar. At the time of writing, the 10-yr U.S. Treasury currently yields 0.95%, while the Chinese 10-yr government bond yields 3.28%. It is now clear that the peg in China has prevented the Renminbi from appreciating, somewhat, but as its economy transitions to service and innovation-driven economy.

The UBS/RMA Survey is instructive.

One could take the opposite perspective and look at capital flows into the U.S. The most recent UBS Reserve Management Survey finds that 90% of central banks surveyed are invested in U.S. agencies; two-thirds are invested in corporate bonds and nearly half of those central banks surveyed are eligible to invest in equities. The U.S. dollar comprises the majority of central bank reserves and their portfolios look particularly similar to those of insurance or pension funds. While it will be unwise to suggest that the assets comprising their portfolios will be invested in U.S.-denominated assets, the secular trend of diversification in equities is much more likely in 2021 as a search for yield is buttressed by ultra-accommodative monetary policy. Furthermore, equity is now an eligible asset class for over 45% of central banks surveyed, which suggest that reserve management practices will likely tilt toward the dollar as central banks have ensured that inflation expectations remained anchored, even as some intervened in capital markets to reduce the negative impact of capital flows. As a result, the envisaged capital flows can be deemed precautionary and necessary if central banks attempt to stave off financial stability risks. The practice of central bank diversification is well entrenched in reserve management practices.

The BRI will drive financial flows’ into Asia.

Furthermore, currencies across Asia, specifically the Singaporean dollar and the Hong Kong dollar will likely appreciate as a result of capital inflows linked to the Belt and Road Initiative. Comparing with other off-shore major centers, such as the Netherlands and Luxembourg it is clear that Hong Kong and Singapore offer key advantages over their counterparts in terms of cross-border syndicated loans both to the BRI and non-BRI countries. In Singapore, the BRI region has an absolute advantage in terms of both value and number of deals. In Hong Kong, this is different as it accounts for 68% of total deals, hence the likelihood of more capital flowing into these regions over the medium term.

This will increase the export competitiveness of dollar products, whilst keeping a lid on the currency. The dollar is unlikely to wane significantly as it comprises the majority of central bank reserves’ and its military and geopolitical clout — facilitated by the SWIFT — will ensure that it remains a dominant currency. In the dominant currency paradigm, Gita Gopinath shows that the invoicing channel has caused a permanent link between dollar holdings and financial stability. This was even clearer following COVID-19, where liquidity constraints across the financial sector caused financial stability risks. The Fed occasioned liquidity swaps to reduce liquidity constraints for a number of central banks, which denotes the salience of the dollar as an anchor for global financial stability. The temporary dollar liquidity swap lines were designed such that up to $60 each for the Banco de brazil, Bank of Korea, Reserve bank of Australia, Banco de Mexico, Monetary Authority of Singapore, and the Riksbank.

Meanwhile, a $30 billion swap line was set up for the Danish National bank, Norges Bank, and the Reserve Bank of New Zealand. These facilities serve as an important liquidity backstop to ease strains in global funding markets, thereby helping to mitigate the effects of such strains on the supply of credit to households and businesses, both domestically and abroad.

It is logical to ask what factors will drive the dollar going forward? A mix of transient domestic factors and global macroeconomic developments will determine the appreciation in the greenback and the extent to which this proves lasting. On the one hand, the U.S. economic recovery could precipitate a surge in the dollar, but this will be accompanied by synchronous improvement in the global macroeconomic backdrop. The extent of global recovery is equally contingent on U.S. imports and domestic economic activity. However, the dollar will likely fare well against the Euro as the interest rate differential coupled with faster economic growth will sever as the backdrop for the exchange rate differential. The ECB currently has its key deposit facility in negative territory at -0.50% while the FED lowered its key policy rate to 0.25%, which suggests an up-side for dollar-denominated assets. It is not clear if COVID-19 will wax and wane as vaccines are being distributed, but the dollar’s dominance isn’t over, the undue appreciation following COVID-19 is.

Finally, the U.S. deficit will continue to weigh on potential GDP growth, which will have an adverse impact on the dollar. From a trade perspective, U.S. exports will become more competitive in a politically polarised world, where higher unemployment and slower wage growth continue to underpin the U.S. recovery. The economic recovery from COVID-19 will be gradual and the forces implicit in the dollar’s appreciation will be largely absent.

That being said, one cannot expect a protracted depreciation forever, as the dollar’s interactions with other currencies and economies will determine its salience over the medium term. It might be unwise to overstate the dollar’s demise as its salience might lessen over time, but this will likely happen gradually. COVID-19 is not an inflection point in the dollar story; it’s an exogenous shock that will dissipate over time and with it, the value of the dollar. Of course, this article is not an exhaustive list of determinants of the dollar’s future value. Even so, the U.S. dollar is ridden with characteristics that continued to maintain its hegemony. The Federal reserves’ status as the global lender of last resort as well as the dollar’s role in global trade and finance will prevent a structural depreciation to accrue to it.

Conclusion.

However, this trend will come across a number of impediments such as more global Euro, a resurgence of economic activity across the globe, and diversification of payment away from the SWIFT. Meanwhile, the Belt and Road Initiative will likely integrate Asia more than one currently expects, causing countries across the region to accept payments in indigenous currencies such as the South Korean on, the Malaysian Thai bat, and the Chinese Yuan. However, the composition of reserves and investment trends from central banks across the world suggest that the dollar’s dominance is unlikely to fade just yet. If anything, its role as an anchor to global financial stability is indispensable for staving off liquidity shortages and banking crises. Nevertheless, a more globalized market with digital currencies will reduce the dollar’s salience across global trade and finance.

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