The strength of the US dollar has been palpable this year, with the currency rallying about 20 per cent, retesting 20-year highs. The pain felt across G10 nations has been most acute in Japan and the UK, with the yen and pound some 20 per cent weaker, while the euro is down 15 per cent.
Other Asian currencies have weakened but remained largely resilient compared to the G10 currencies, apart from those commodity-linked ones such as the Canadian and Australian dollar, and Swiss franc. Widely considered a safe haven, the Swiss franc has lost nearly 8 per cent.
A strong dollar is a double-edged sword. For the US, it makes imports cheaper and relieves pressure from imported inflation, but also hurts exports since these become more expensive for overseas customers. For the rest of the world, a weaker local currency may boost export competitiveness but it also brings worries about imported inflation, especially for those reliant on energy and food imports.
A strong dollar traditionally triggers capital outflows from emerging economies. With the risk of financial instability, local central banks have often been cornered into following the US Federal Reserve in raising interest rates aggressively to defend their currencies.
As currency markets are essentially a zero-sum game, a weaker and more stable dollar would be a relief for the rest of the world. But it is still an open question as to when the dollar will peak.
There are two key reasons for dollar strength this year. First, interest rate differentials have widened between Treasuries and the government bonds offered by other developed markets as central banks lagged behind the Fed’s hawkishness. This drove demand for Treasuries and pushed up the dollar.
Second, as geopolitical risks heightened – think Ukraine and Taiwan – and fears of a global slowdown intensified, investors have increasingly flocked to the dollar for safety.
Even as central banks continue to play catch-up with the Fed, a peaking of the dollar may be delayed as investors wrestle with global recession fears, keeping volatility elevated across assets. But, in the next few quarters, investor sentiment about a recession may be closer to bottoming out, so that “less bad” news could fuel a turnaround in non-dollar currencies.
Even though Asian currencies as a whole have remained relatively resilient, individual situations vary.
The yen’s weakness, for example, is a result of the Bank of Japan’s view that demand-led inflation is not well-anchored. It sees a need to maintain accommodative monetary policy to support economic recovery. This contrasts sharply with the aggressive tightening by the central banks in other developed markets. Although Japan intervened in the market earlier this month by buying yen to curb its fall, this was probably done to slow the depreciation rather than start a reversal.
China’s currency has also weakened, going past 7 yuan per dollar for the first time since July 2020 (and down 12 per cent so far this year) to record lows. But this is more a reflection of dollar strength than any fundamental yuan weakness as the currency is largely stable against a basket of currencies.
In response to the depreciation, however, Chinese authorities have introduced measures such as cutting the foreign exchange reserve requirement ratio and imposing a risk reserve requirement for banks buying foreign currencies in forward trading.
For the rest of Asia, the weakness of the Taiwan dollar (down 15 per cent in the year to date) and South Korean won (down 21 per cent) reflects coming challenges as export demand softens alongside global growth. Indonesia (down 6.6 per cent) and India (9.8 per cent) have been more resilient.
Commodity exporters such as Indonesia are benefiting as high commodity prices boost current account surpluses while the domestic supply of food and energy keeps local prices stable. For India, an improved current account balance and a proactive Reserve Bank of India, which has raised rates to address inflation, have lent support.
It should also be noted that most Asian economies have maintained positive real rate differentials against the dollar, which should continue to support their currencies.
Continued uncertainty about global growth and the resulting aversion to risk are likely to keep the dollar strong for now. Continued Fed hawkishness until inflation is sufficiently contained also means US interest rates will stay high.
This could result in moderate depreciation for G10 and Asian currencies. But the risk of a currency crisis in major Asian economies remains low, considering their improved current accounts as a percentage of gross domestic product and ample foreign exchange reserves.
Clara Cheong is a Singapore-based global market strategist at JP Morgan Asset Management