For how long will the world economy tolerate US dollar strength?
- Exchange rate shifts reflect fundamental big-picture structural changes, and the strength of the US dollar matters in the geopolitical power game
- If the markets perceive that macroeconomic management is flawed, like what happened in Britain, they can be brutal in punishing such mistakes
The Bank for International Settlements (BIS) recently issued a paper looking at the policy implications of exchange rate swings. The US dollar index has broadly appreciated 10 per cent against the other currencies since the beginning of the year, 15.2 per cent since its recent low in June 2021 and 46.8 per cent since its 12-year low in August 2011.
Where you stand depends on where you sit. Economists tend to look at prices and flows, which are changes in stock over time, because these are the most readily available numbers.
However, if you look at Earth from 30,000 feet up, you see broadly the stock position while flows are small changes from that height. At ground level, you only see flows because the big stocks do not appear to change that fast.
What Japan did had world-shaking implications that many analysts ignored. With the big swings in the yen, Japanese GDP in yen terms has been roughly flat but in US dollar terms has declined from a peak of US$6.27 trillion in 2012 to US$4.9 trillion at the end of 2021. However, in terms of net international investment position, Japan has built up a formidable war chest of 411.2 trillion yen (US$2.8 trillion).
The architect of this transformation is Governor Haruhiko Kuroda of the BOJ. Under his watch, the BOJ now owns more than half of Japanese government bonds, continuing to buy them to maintain a flat zero yield curve under what is called yield curve control.
In effect, Japanese pension funds are protected from Japanese inflation and interest rate increases since long-term bonds are shifted to BOJ balance sheet. BOJ holdings of Japanese government bonds are US$3.6 trillion, almost identical to net Japanese surplus in foreign assets.
How does US dollar strengthening affect global balance sheets? The US net liability position has deteriorated to US$18.1 trillion at the end of 2021, of which Japan accounted for about 20 per cent and East Asia surplus economies – Japan, China, Hong Kong, Taiwan and Singapore – accounting for almost 56 per cent.
As the BIS analysis shows, US dollar strengthening is generally bad for the world economy because higher US interest rates tighten trade finance liquidity and weighs on financial stability on those sovereign and corporate borrowers in US dollars.
The US economy is sitting pretty from a macro perspective, but how long can the US dollar continue to strengthen? The global rich class loves a stronger US dollar because it protects their interests, but they worry that global liquidity tightening will result in deflation. When it begins to weaken, expect no loyalty from the rich.
This balance sheet view shows that exchange rate shifts reflect fundamental big-picture structural changes, and the strength of the US dollar matters in the geopolitical power game. If the United States uses this window of opportunity to do major reforms, the strength of the US dollar would reinforce the view that the US is back.
Andrew Sheng writes on global issues from an Asian perspective