The Impact of The Dollar on Global Economic Development
The US dollar is a better instrument of determining the risk in the global financial industry than the CBOE Volatility Index (VIX). This means that the stability of the dollar translates into calmness in the financial markets. However, a soaring of the dollar creates risks that are not covered on the VIX index on the global economy.
The Role of the US Dollar in the Global Economy
After the completion of the Second World War, the dollar became the world’s reserve currency. This status has both positives as well as negatives. A majority of currencies, goods and even debts are valued in US dollars. Moreover, it is the preferred currency for most international trade transactions. Therefore, any entity that wishes to participate in any transaction must either own or purchase US dollars beforehand.
According to a recent report by IMF on the Currency Composition of Foreign Exchange Reserves (COFER), the dollar makes up 62% of global foreign currency reserves. It is followed at a distance by the Euro which sits at 20%. This is sufficient proof that the dollar is still the most dominant fiat currency.
The Effects of a Strong Dollar
The data from the IMF implies that the dollar is the base currency for international lending. Long supply chains require working capital to facilitate their processes. This capital is provided by financial institutions and issued in the form of US dollars. However, the IMF discovered that the soaring of the dollar translates into fewer loans for clients in developing economies. The reduction of loans has adverse effects on the development of emerging economies.
There is an argument that a devalued fiat currency for a country whose exports exceed imports is beneficial to that country. This is because foreign buyers acquire the exports at cheaper prices, prompting them to buy in bulk, thereby boosting the country’s economy. As per IMF, this benefit is outweighed by the reduced lending and subsequent sluggish economic development rate. Essentially, when the dollar performs well against local currencies, bank reduce lending, slowing down the economy. Consequently, borrowers default on loans, encouraging the banks to further tighten the lending requirements. Throughout this cycle, it is the economy that suffers the most.
The Influence of the US Federal Reserve on the Dollar
Despite the perception that the US Treasury has control over the value of the dollar, it is worth knowing that the actions of the Federal Reserve have an impact on this value. The reduction of interest rates with Quantitative Easing by the Federal Reserve made the lending process cheaper. As a result, investors took loans in the US and banked the money on other countries with higher interest rates. This spurred massive economic development in emerging economies.
Quantitative Easing significantly weakens the dollar. The IMF report indicated that a weak dollar means increased lending by banks to developing economies. However, if this trend is reversed, the economic bubble bursts. An ideal example of this is the economies of Turkey, Argentina and Brazil.
It is characteristic of corporate giants to store their funds in foreign bank accounts. These monies amount to trillions of dollars. The main reason for this culture is the reduced tax rates for profits that are held in international bank accounts.
As mentioned above, American institutions access loans at cheap rates. This money is then disbursed to foreign banks which are expected to pay higher interests, profiting the original borrowers. This is known as the carry trade.
Lately, carry trade has become a risky venture due to the weak nature of emerging economies. Also, the US government has reduced taxes imposed on foreign profits. This means that American companies can now repatriate the dollars in foreign accounts. This will result in a stronger dollar and a further decline of the emerging economies.
The repatriation of dollars will weaken the currencies of the developing world. In turn, these economies will indulge in a deleveraging process to raise funds for loan repayment. Since a stronger dollar means more deleveraging, the dollar is new VIX.
Are Cryptocurrencies The Solution?
The reason for the introduction of digital currencies was to provide a better and automated alternative to fiat money. The underlying blockchain technology ensures that cryptocurrencies are not affected by central banks, political tensions and capital flows like the fiat monetary system.
The independence of a crypto-based financial system makes it the perfect replacement for the existent systems that are adversely affected by a strong dollar. During a financial crisis in 2013, Cypriots resorted to using Bitcoin. Brazil and Russia have also witnessed an increased interest in cryptos of late, as per data from Google trends. While the mainstream adoption of digital currencies is still far from realization, the attraction towards this emerging asset class is a trend that is worth keeping an eye on.