The Impact of a Strong Dollar on the Global Economy

A strong dollar has often been deemed a “wrecking ball” for the global economy due to the following factors:

• Increased Trade Costs: A robust U.S. dollar raises the cost of international trade, especially impacting emerging markets.
• Financial Conditions: The tightening financial conditions and inflation are particularly challenging for countries with limited financial buffers.

Capital Economics, however, argues that concerns regarding the damaging effects of a surging dollar are exaggerated. They emphasize:

• An appreciating dollar is problematic in the short-term but not as detrimental as frequently presumed.
• As of now, the dollar has appreciated by 7% compared to the previous year, achieving a record high.

Trade Dynamics

Most traded goods are priced in dominant currencies, primarily the U.S. dollar. Therefore, as the dollar strengthens, global trade costs increase. Nevertheless:
– The negative impact on trade due to a strong dollar has been overstated.
– The services trade, which constitutes 20% of worldwide trade, remains less affected.
– Decreasing commodity prices can offset import cost increases, potentially easing inflation.

Emerging Markets

Financial tightening from dollar strength presents a lower threat to emerging markets compared to previous decades, with currency risks at historically low levels.

Underlying Risks

Despite the diminished immediate risks from a strong dollar, two hidden threats are identified:
1. Renminbi Depreciation: The People’s Bank of China has kept the renminbi close to 7.3 per dollar, but this is vulnerable to U.S. tariffs.
– If tariffs escalate to 60%, the renminbi might weaken to 8.0 per dollar, impacting other Asian currencies and emerging market assets.
2. U.S. Trade Deficit: A strong dollar harms U.S. exporters and enhances importers’ purchasing power, worsening the trade deficit and inviting protectionist policies.
– Increased deficits lead to growing U.S. net external liabilities, heightening the risk of disorderly adjustments in the future.