Why investors are wrong about the role of the dollar

It is widely accepted that dollar strength is bad for emerging markets (EM), something that seems to have been confirmed by a very tough 2018 for emerging market assets. However, the traditional reasons why, such as investors’ attitude to risk or prevailing financial conditions, are increasingly being questioned.

A growing body of evidence suggests that it is really the dollar’s role as the dominant "invoice" currency in world trade that explains its impact on emerging markets.

According to this interpretation, a stronger dollar reduces global import demand by simultaneously raising import prices for all countries apart from the US. At the same time, it raises the cost of credit, particularly in economies where dollar-denominated debt is prevalent. A stronger dollar is therefore a clear headwind to EM growth, generating inflationary pressure regardless of what trade-weighted exchange rates may be doing. It means that central banks have a clear incentive to fight depreciation of their currencies against the dollar, given that it offers little benefit to exports, while generating higher inflation.

This holds several lessons for investors. One is that, with emerging markets at least, it may be better to focus on the exchange rate versus the dollar rather than the trade-weighted exchange rate when considering a currency’s valuation, whether a currency adjustment will correct external imbalances and in judging inflationary effects. Reliance on purchasing power parity, real effective exchange rates and other “fair value” measures will not lead to robust investment conclusions.

We may also need to adjust our thinking on how emerging market central banks should react, assigning more of a role to currency stability than inflation and growth. Dollar strength may lead to more policy tightening than normally expected. This has particular implications for bond and currency investors, but should not be ignored by equity investors in emerging markets either, given the role that monetary conditions play in equity markets.

This new dollar invoicing theory is challenging the way economists and markets have previously thought about currencies and their impact on economic and financial variables. We believe it provides a more complete picture of how and why the dollar is so important to emerging markets, and why it has a greater impact on global trade and inflation than is generally appreciated. For investors, this has important implications across all EM asset classes.

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