eBusiness Weekly
Note from ZNCC
Similar to what most Central Banks have been doing in the past few months, the US Federal Reserve has been tightening financial conditions by raising interest rates.
The rising interest rates in the US and other developed countries like the United Kingdom and the European Union has seen the shift in investor preferences from holding assets in emerging and developing economies to the developed world. Particularly, the rising US interest rates has seen an increased demand of US assets and a rise in the value of the US dollar denominated assets.
In this regard, it can be noted that investors prefer holding assets that tend to appreciate in bad times and as such, debt issuance in dollars is both investor-driven and borrower-driven. This begs an answer to the question: what impact do the rising US interest rates and a strong dollar have on the rest of the world? This week’s edition of the Note from ZNCC seeks to provide an analysis on how this will impact the rest of the world, especially developing countries.
The dollar is the most common currency of choice for debt contracts worldwide. According to the Bank of International Settlements, the dollar-denominated credit to non-banks outside the US amounts to around US$12 trillion. Indeed, there is a great deal of dollar-denominated debt outstanding in the world, outsized relative to the wealth or GDP share of the United States.
The US dollar is the dominant currency in international finance, much as the British Pound Sterling was prior to the dollar, and as the Dutch Florin was prior to the Sterling. The ease of settling obligations in dollars begets new issuance in dollars.
As more dollar debt is issued, some of this issuance adds to the stock of dollar-denominated money-market instruments and expands the supply of available assets that can be used by other issuers to extinguish their debt. Dollar debt begets dollar debt, bootstrapping itself, thereby leading to currency dominance.
Also, the US dollar serves as a reserve currency for most central banks around the world. The US dollar’s dominance in global debt denomination has also generated incentives to invoice trade in the same currency. For example, oil producing and exporting countries only issue US dollar invoices and most international commodity prices are quoted and paid for in US dollars.
However, despite the currency’s presence in global trade, international debt, and non-bank borrowing still far outstrips the US share of trade, bond issuance, and international borrowing and lending, central banks aren’t holding the greenback in their reserves to the extent that they once did. Governments that default on their debt risk losing access to international markets and the ability to finance critical functions.
Rising interest rates have an impact on people’s lives and the day-to-day running of business operations from how much one pays for a car loan to how much the money in a personal or business bank account is worth.
For instance, when interest rates go up, the value of a country’s currency or money in general, usually also goes up relative to the value of other countries’ currencies. Higher interest rates entail high return on investments and stands as an attraction for foreign investors thereby increasing the demand for the currency and raising its value in the process. Using the US dollar as an example, the Federal Reserve made a series of rate hikes in more than two decades and raising its rate hikes seven times in 2022.
This was inevitable to keep inflation under control and ultimately, the US economy stable. Subsequently, higher interest rates boosted returns on US assets, increasing the demand for the dollar, and raising its value relative to other currencies. And that had a global impact because about half of world trade, including oil is invoiced in dollars. Countries that are net exporters, or export more than they import, can fare better against a strong dollar because they have access to US currency and are less reliant on imports with rising prices.
For the rest of the world, especially developing nations like Zimbabwe, a stronger US dollar can exacerbate inflationary pressures as it raises the prices of imports that many emerging markets and developing countries rely on like fuel, fertiliser and food. For economies with high dollar-denominated debt, a rising dollar value can weaken economic growth and even cause debt distress or financial crises.
This is so because a stronger dollar makes debt in foreign currency harder to repay, leading companies to reduce investment, and possibly even pushing some into bankruptcy.
Thus, central banks in these countries are in a precarious position. The central banks are supposed to raise interest rates to tame inflation even though that poses risks to growth and financial stability.
Countries with high inflation need to raise interest rates to bring prices back under control. This is definitely a priority because the inflationary pressures remain high or elevated, the harder it will be to bring it down to permissible levels.
However, central banks do have a toolbox of other policy instruments at their disposal beyond interest rates.
For example, central banks can embark on open market operations or interventions on the currency market which could be helpful for some countries that have done much of their borrowing in dollars or other foreign currencies. However, there are downside risks to the use of these tools in that it makes it difficult for economic agents to fully understand and comprehend the position of the central bank’s monetary policy. For example, a central bank purchase of assets may give the impression that monetary policy is loosening even though that’s not necessarily the case. In this regard, these tools must be used with care and communicated effectively and religiously.
The Global Economic Prospects Report of January 2023 predicted that the world economy will enter into a recession in 2023 or 2024. Global slowdown is expected due to uncertainty which will hamper investment coupled with high global interest rates. This follows a string of crises that have rocked the global economy including the coronavirus pandemic.
Supply chain bottlenecks, the war between Russia and Ukraine, and a series of climate-related disasters that have imperiled the world’s food and energy supply. In an anxious world, the dollar has traditionally been a symbol of stability and security. The worse things get, the more people buy dollars. The outlook for the United States has remained gloomy following the collapse of the Silicon Valley Bank and Signature Bank, while that of China has improved following the relaxation of the Covid-19 restrictions in the first quarter of 2023.
Given all this turmoil, is a global currency crisis at hand? This question seems a little too broad, but it might be true for certain currencies. In line with the Zimbabwe National Chamber of Commerce’s theme for 2023, these are the economic realities that the business world is facing today and it is of paramount importance to transform such realities into market opportunities.
Rising interest rates are favourable to the lender but certainly unfavourable for the borrower. For investors with buffers, rising interest rates and strengthening US dollar entails higher returns for investment, especially in assets that tend to appreciate even during bad times.
As the US economy continues to fight inflation, further Fed rate hikes are expected. As the strong dollar and rising interest rates are bad for the world, many countries unfortunately have few options to address the associated problems in the short term. According to the International Monetary Fund, these issues are best dealt with pre-emptively rather than reactively.
Thus, to prevent the next crisis, countries should act now to shore up their fiscal position and engage in sustainable borrowing.
At the moment, it is difficult to predict the future direction of the US dollar when there are so many moving parts in the world economy. However, the expectation is that with persistent inflation in the world, the United States is forced to keep raising interest rates and that together with geopolitical shocks from war and sovereign debt defaults, will probably keep the dollar high.
ZNCC, The Voice of Business.
This article was prepared by the Zimbabwe National Chamber of Commerce for Business Weekly
