In theory, the creation of currency facilitated exchange between two individuals and provided a tangible store of value for any person wanting a transaction, but offering a service instead of a direct good. As the worlds of early societies shrank, groups and cultures with differentiated economies began to seek formal relationships, a new problem arose – what was one unit of currency A worth when held up against one unit of currency B? Foreign exchange rates play a much more prominent role in currency denominations today than when gold used to be exchanged for grain. But prominence has come hand in hand with complexity. Not the least of which is that now the currencies underpinning financial products themselves offer direct indications of the health of both the product being sold and the nations whose in whose currency these products are underpinned.
In this, it becomes apparent that certain currencies have greater value per unit than others – the primary example being the American dollar, the global standard for trade. The US dollar has risen to prominence because, amongst other reasons, it is the primary currency used in commodities markets, such as gold and petroleum, and the growth of the American economy since the Second World War has ensured that the dollar poses a secure base for transactions given it’s historical stability and widespread usage. These factors have contributed to the American dollar becoming the unofficial global reserve currency and the official currency adopted in developing nations across the globe.
Here, an ironic turn emerges – the stability of the dollar, and therein dollar-denominated debts, is both a blessing and a curse. A ‘strong’ dollar (a comparative measure indicating when the US dollar has risen to historically high levels relative to other currencies) has numerous ripple effects within surrounding economies. A risk emerges when examining companies with reserves or debt denominated in foreign currencies – a strong dollar acts as a trend amplifier that is strongly felt within capital reserves, causing markets to flee to the dollar when faced with the prospects of a bearish market. This stampede and ensuing dollar binge only exacerbates the existing problem and sees greater amplification of markets fleeing towards ‘stability’ (debt often denominated in either American dollars or Japanese Yen, another notoriously stable currency).
A strong dollar is typically met with raises in interest rates from the Federal Reserve, therein increasing the cost of borrowing the dollar and (hopefully) acting as a stabilizing force within the market to reduce the dollar binge. But an ascendant greenback also stunts inflation, thereby making foreign goods cheaper for any individual or entity holding the dollar. This means that while markets adjust to interest rate hikes, consumer behaviour and buying patterns can continue to act as a short-term counter-measure to the efforts of central bankers. An additional impact is being felt on foreign shores – sharp falls in currencies force central banks to either raise interest rates in an effort to prevent depreciation and avoid the worst of ongoing deflation. Alternatively, a strong dollar can force economies to lower interest rates to historic lows in an effort to attract investment and spur domestic spending when individual currencies become ‘weaker’ and the decrease in the real value of savings hits the portfolios of consumers. This puts the Federal Reserve in an awkward position – raising interest rates risks undercutting global economic growth, thereby seeing downturns in economies currently struggling who lack the traditional fiscal and monetary mechanisms to mitigate adverse impacts. But keeping interest rates low fails to address the issues currently simmering that threaten to cripple growth across the globe.
Why does this matter? The number of currencies that move in line with the greenback encompass 60% of the world’s total GDP. The volume of dollar denominated bonds held in developing markets amounts to over $3T and each time the dollar rises, so does the cost of servicing those debts. A strengthening dollar could see a spiral emerge of capital outflows, now going towards paying debts instead of domestic investment, and the resulting fall in asset prices could lead to an economic downturn similar to that experienced by Brazil during the last 5 years. Presidential promises to lower corporate tax rates expressly aimed at American companies in order to facilitate the repatriation of earnings onto American soil would see rocket fuel added to the rise of the greenback, and protectionist measures would directly impact American consumers as the cost of imported goods increased and export growth continued to decline.
Despite all the talk of trade deficits throughout the 2016 presidential campaign, the reality remains that the United States can entirely afford to operate at a continuous trade deficit due to the high demand for debt instruments denominated in American currency that generates capital inflows capable to subsidizing a deficit. But that does not mean a deep structural issue does not exist – The strength of the American dollar poses a threat to all, from domestic consumers and foreign governments. As the worlds buffers for mitigating financial downturns shrink, the likelihood of the next recession being felt more severely by consumers increases – and whichever one of currency A or B you use, you can take that to the bank.