27 October 2022
The US Dollar’s climb has slowed in recent weeks, but its strength is still unmistakable: over the past month or so, it’s reached levels last seen in the early 2000s. It’s also appreciated by about 22% against the yen, 13% against the Euro, and more than 10% on average against major emerging market currencies since the start of this year.
You can read more about US Dollar strength and what it means for your investments in our August edition of CIO insights. In short, the US Dollar’s strength can be attributed to:
The US Federal Reserve’s aggressive rate hike cycle
The USD’s status as a safe haven currency
The US economy holding up relatively better than those of other countries
But the flip side of USD strength is weakness in other currencies. And this month, we’re looking into how other countries have reacted to higher foreign exchange (FX) volatility, and how instances of currency weakness have played out in the past.
As you can see in the chart below, most global currencies experienced the bulk of their declines from March this year, when the Fed began its aggressive rate hike cycle.
Excessive currency weakness against the USD is unwelcome news for an economy, because it could drive up import costs and inflation, or make a country’s USD-denominated debt more expensive to repay.
As a result, some countries have resorted to intervening in the foreign exchange markets or taking other extraordinary measures to support their currencies. Foreign exchange intervention is when a central bank buys (or sells) its currency in the foreign exchange market to strengthen (or weaken) its currency.
Japan’s central bank, the Bank of Japan, spent almost $20 billion USD in late September to prop up the yen, which had slid to a 24-year low. This was its first intervention in the currency markets since 1998. While the yen briefly recovered, it’s since fallen to fresh lows, and the Bank of Japan is suspected to have intervened again in October.
The IMF estimates that emerging countries have sold off more than 6% of their foreign exchange reserves in the year to July to limit currency depreciation.
In the UK, the GBP has been pressured not just by a strong USD, but also by investor skepticism over the (now scrapped) budget announced by the government under former prime minister Liz Truss. The Bank of England resorted to an emergency bond purchase to support its bond and currency markets.
Because global economies are so interconnected, large swings in a single currency can often affect the broader region or even the rest of the world. Let’s look at history to see how some currency crises have played out.
The Asian Financial Crisis began in 1997 when Thailand de-pegged the baht from the USD. Thailand had built up an unsustainable reliance on foreign debt, and its currency came under attack from speculators who were concerned about imbalances in the Thai economy.
The Thai central bank eventually ran out of foreign exchange reserves it could use to defend its currency (by selling USD and buying THB). And foreign investors pulled their money out of other Asian countries that they thought had similar economic weaknesses, leading to a domino effect of currency devaluations across the region.
The IMF intervened and provided loans to stabilize the affected Asian economies, but the damage had been done, with many economies falling into deep contractions.
Investors have been drawing parallels between the pound’s decline today and its devaluation in 1976. In the 1970s, high inflation (at close to 25% in 1975), high oil prices, and a large government budget deficit contributed to the pound falling by 35% between 1975 and 1976.
Fearing that further devaluation would worsen inflation, the British government requested a $3.9 billion USD loan from the IMF – the largest ever loan from the IMF at that time – which came at the cost of deep public spending cuts.
Currency crises occur when a currency’s value suddenly drops, leaving countries unable to pay for their imports or pay off their foreign-currency-denominated debt. These types of crises are difficult to predict as there can be many different triggers. But these episodes have a few factors in common:
Economic weaknesses, such as persistent deficits, low growth, high inflation, or faults in the financial system
Loss of investor confidence or a speculative attack, resulting in investors selling off the currency
Strong policy action by the central bank or government, such as interest rate hikes or fiscal tightening, to prop up the currency. These policy actions generally result in sharp economic downturns.
No one knows for sure, as the triggers for crises are often unpredictable. While there are some parallels to the past (for example, higher debt levels due to COVID support, and persisting current account deficits), there are also some notable differences:
The sterling’s 20% decline versus the dollar since mid-2021 is still a way from the 35% slump it experienced in 1975-76. But there are concerns about the sustainability of the UK’s government debt, and higher interest rates are pushing up its borrowing costs.
The economy appears to face similar challenges to the 1970s. Inflation has climbed to 10% as of September amid surging energy costs. Its current account deficit, at 4.3% of GDP as of Q2, is worse than the 3.8% of GDP deficit at the end of 1974 - prior to the start of the 1970s Sterling crisis. Meanwhile, public sector debt as a share of GDP at 98% as of September is at levels last seen in the 1960s.
That said, recent developments with the election of former UK finance minister Rishi Sunak as prime minister has calmed market concern over the previous government’s economic plans – though the new government also has to figure out how to balance the books.
The Japanese yen has declined by 22% against the USD this year, mainly because of the contrasting approaches of the Japan and US central banks – with the Bank of Japan leaving its interest rate low to support the economy’s recovery and the Fed continuing to rapidly hike rates. A widening trade deficit due to higher energy costs is further contributing to the yen’s slide.
Although Japan has already spent billions of dollars to prop up the yen, it still has a FX reserve stockpile of about $1.1 trillion USD. But while such intervention may stem the bleeding for a short amount of time, it's not a sustainable way to address yen weakness.
Asian currencies have seen broad declines this year, but they haven’t collapsed as they did in 1997-98. Today, Asian countries have significantly lower debt levels and higher foreign exchange buffers than they did during the Asian Financial Crisis.
There are pockets of weakness elsewhere in emerging markets. Some economies are under pressure due to higher debt burdens accrued during COVID, soaring borrowing costs, and weaker currencies. A few, like Russia and Sri Lanka, have already defaulted.
As the Fed continues to hike interest rates, global currencies may continue to see weakness. But as we’ve seen in the UK, other country-specific factors can contribute to currency volatility.
An important caveat: While the Fed has clearly communicated that its focus is squarely on its own economy, officials have also said they are attentive to the risks of its policies on global markets and the global economy.
And ultimately, should global economic weakness start to pose a threat to the US markets and economy, that could prompt the Fed to pull back on its aggressive tightening path. We saw that happen during its 2015-18 tightening cycle, when the Fed paused on rate hikes and reversed course on its quantitative tightening plan after market volatility spiked.
As the US economy shows signs of cooling, markets are seeing a top to the Fed’s current hiking cycle. But even though the light at the end of the tunnel may be nearing, that doesn’t mean there won’t be any road bumps ahead – and as history shows, these can be unexpected.
You can prepare for these market shocks by investing in a globally-diversified portfolio and setting aside emergency funds for unexpected expenses. We’ll continue to monitor macroeconomic conditions and the numerous factors – from monetary policy and market volatility to currency and geopolitical risks – that could impact the global economy.