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

Andrew Sheng

Published: 4:34pm, 4 Nov 2022

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After the US Federal Reserve raised interest rates by 75 basis points for the fourth straight time this year, financial markets are beginning to shake. The interest rate rises in response to higher inflation is a reversal of nearly two decades of generally declining global interest rates, higher asset bubbles and anaemic growth.

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.

The Japanese yen hit a recent low of 150 to the US dollar on October 20. Eisuke Sakakibara, Japan’s former vice-minister of finance who is known as “Mr Yen”, has hinted the yen could go to 170.

The BIS attributes three factors to the appreciation of the US dollar: an improvement in US terms of trade with higher oil prices that affect Europe and Japan as oil importers; divergence in monetary policy stance as the Fed is more aggressive in raising rates than the European Central Bank or Bank of Japan; and flight to quality because of war and fears of recession.

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.

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Reality requires us to look at both stock and flows, which is why we must examine the balance sheet effect of price and flow changes. The Japanese were the first to understand the process of ageing and balance sheet effects.

After the 1980s asset bubble reversals arising from the rapid appreciation of the yen versus the US dollar, Japan went through a balance sheet deflation. That meant Japanese companies and households spent the next three decades rebuilding their balance sheets aided by near-zero interest rates.

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).

In other words, in preparation for an ageing population plus slower domestic growth, Japan shifted its financial assets abroad on a massive scale so that depreciation in the yen would mean higher income and wealth effects from foreign earnings.

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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.

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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.

While European and Japanese interest rates become cheap in relative terms as the US dollar strengthens, the carry trade will increase. This accelerates dollar strengthening until it’s time to take profits. The carry trade was instrumental to financial accidents in both the 1997 and 2008 crashes.

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.

If the markets perceive that the macroeconomic management is flawed, like what happened to sterling in September, then the markets can be brutal in punishing such mistakes. This is why I am watching for if and when BOJ monetary policy reverses course. That is when small waves could signal a tsunami ahead.

Andrew Sheng writes on global issues from an Asian perspective