— Reuters
After gaining 7.1% last year, the US dollar index has depreciated by 8.3% as of Nov 18, with its decline gaining momentum right after the announcement of reciprocal tariffs by the United States on April 2.
This puts the greenback on track for its worst year since 2017.
In 2017, the US dollar lost close to 10% of its value, and the most impactful factor was the “Trump slump” brought on by concerns about the Trump administration’s ability to fulfil its economic agenda as initially promised.
In addition, Trump’s provocative rhetoric was not only fanning the flames of economic uncertainty, his threatening to unleash “fire and fury” or shut down the government did not inspire market confidence.
Since the end of last year, the US dollar’s fall has been even more remarkable, down by 9.8% to 108.37 on the US dollar index in January to 97.77 in August.
The pillars of strength for the currency have been weakening due to structural and cyclical challenges, starting with concerns that tariffs would weigh on the US economy and unleash inflationary pressures, stirring the risk of stagflation.
Meanwhile, the US Federal Reserve (Fed) is currently embarking on a rate easing cycle, though with caution against the risk of inflation rising, narrowing the yield differential with other major central banks and some central banks in emerging markets that had supported US dollar strength.
The combined effects of a shrinking of the US growth premium and yield advantage make the US market, including US dollar-denominated assets look relatively less attractive to foreign capital.
The US fiscal picture and rising debt are worrying and pose risks to fiscal stability.
America’s budget deficit is estimated at 5.8% of gross domestic product (GDP) this year, and its debt stood at US$36.2 trillion or 118.8% of GDP of the end of June.
As the deficit widens and debt increases, the confidence of investors in the US government’s ability to manage its deficit and repay its debts drop, making them less willing to hold its assets, including the US dollar.
Markets are now placing greater emphasis on US policy credibility. Political challenges to the Fed’s independence significantly impact market perceptions by increasing uncertainty and volatility, raising fundamental questions about the credibility of US policy, potentially leading to a reassessment of the greenback’s status as a global reserve currency.
What does a weak US dollar mean for the emerging economies?
The impact of a weaker greenback is complex and not straightforward because it creates both positive and negative outcomes for different parts of the economy.
A weaker US dollar can boost US exports and increase the earnings of US multinational corporations with significant overseas operations.
Converting foreign profits back into a weaker US dollar, makes the earnings worth more.
On the flip side, a weaker US dollar increases the cost of imported goods for American consumers and businesses. This combined with tariffs, fuels consumer inflation and lowers purchasing power.
On balance, preference for a persistently weaker US dollar could threaten a prolonged period of stagflation.
For emerging-market economies, a weaker US dollar can bring a disinflationary impulse by making US dollar-denominated imports and debt repayments less expensive, potentially leading to stronger currencies, falling inflation, faster growth and dovish central banks. This scenario could herald a new bull market in emerging economies.
The shifts in capital flows due to a weaker US dollar could dramatically alter the investment landscape, particularly benefitting supply-constrained emerging markets.
A depreciating greenback acts as a tailwind for emerging market economies as borrowers with US dollar debts and domestic currency assets experience a windfall that strengthens their balance sheets and improves their creditworthiness, thereby supporting their demand for credit.
This financial channel can lead to an increase in the supply of credit, potentially easing financial conditions for borrowers.
A notable period of a sharp US dollar depreciation occurred between 1973 and 1979 after the United States ended the US dollar’s convertibility to gold, effectively ending the Bretton Woods fixed exchange rate system.
The US dollar tends to strengthen during more broad-based global recessions while exhibiting weakness around US-led recessions.
The US dollar strengthened around recessions in the 1970s and 1980s, 2001 and 2020. During the 2001 and 2020 recessions, which were accompanied by a global slowdown, the US dollar benefitted from demand for a safe haven.
However, the currency weakened during the 1990 and 2007 recessions, which were primarily led by the United States.
We can no longer take the greenback’s anchor status for granted as the central banks, especially in emerging markets, are diversifying their reserves away from the US dollar.
There are arguments for and against the US dollar’s future fragmentation.
While the currency’s share of global foreign exchange reserves has gradually declined from 58.9% in the first quarter of last year to 56.3% in the second quarter of this year, compared to 21.1% in euro, yen at 5.6%, pound sterling at 4.8%, Canadian dollar at 2.6% and yuan at 2.1%.
Still, the greenback remains globally relevant, comprising about 90% of foreign exchange transactions, 66% of international debt, and 58% of foreign exchange reserves due to its deep liquidity and stability.
While a complete collapse of the US dollar is unlikely, a shift away from the the currency is a possibility over the longer-term, leading to a more diversified and contested global currency landscape.
If the greenback’s dominance collapses, the transition to new global monetary and payment system would likely experience extreme instability, characterised by significant volatility in financial markets worldwide, with central banks, countries, and corporations holding the US dollar and US dollar-denominated assets suffering financial losses as investors scramble to re-align their portfolio, reserves and payment systems.
Developing and emerging economies will be hit hardest, facing higher borrowing costs and currency instability.
A collapse of the US dollar would likely lead to a dry-up of market liquidity, and a loss of confidence in the currency would trigger widespread financial turmoil and fragmentation.
Market and investor panic would likely lead to a rapid sell-off of US dollar-denominated assets, particularly US Treasuries, which would drain liquidity from these markets and impact other asset classes like mortgages and corporate bonds.
The trend of de-dollarisation is a long-term process that only emerged over the last two decades.
Nevertheless, the International Monetary Fund found that the US dollar still plays “an outsized role” in global markets despite the US economy’s shrinking share of global output.
Many factors continue to underpin de-dollarisation but it is not accelerating at a pace that fundamentally threatens the currency’s global status.
De-dollarisation is most visible in commodity markets and especially in energy markets. Due to geoeconomic fragmentation and the shifting of trade, Russian oil exports to countries like India, China, and Turkey are being increasingly settled in non-US dollar contracts.
The growing use of digital currencies and alternative payment systems for cross-border transactions is an ongoing, and gradual diversification process of the global monetary system, moving away from the US dollar.
Lee Heng Guie is the executive director of the Socio-Economic Research Centre. The views expressed here are the writer’s own.
