The implications of a strong US dollar

Anyone who's been keeping an eye on the foreign exchange market over the last year or so will have seen the US dollar enjoy huge upward momentum. Since last summer, the currency has surged against all of its major rivals, hitting a 12-year high against the euro in March.

Recently, however, it has weakened due to concerns over its impact on the US economy, with President Obama rumoured to have expressed his unease at the greenback's strength to a group of G7 delegates. He has since denied making any such comments, but that old saying 'there's no smoke without fire' is definitely weighing on the minds of market commentators and investors.

"There's a sense that both monetary policy makers and lawmakers may be starting to become uncomfortable with the dollar's strength, and that's starting to cap some of the dollar's upside," said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange.

Despite its recent losses, the dollar remains king thanks to the relative strength of the US economy compared to others around the world, particularly the eurozone where the Greek debt crisis continues to create uncertainty.

So what does the future hold for the dollar? Why could a strong dollar create problems? What impact is it having on US companies, consumers and the wider economy? And what does it mean for other nations?

In reality, there are both positive and negative implications. On the negative side, US firms can lose their global competitiveness when the dollar is strong because their goods and services become more expensive to foreign buyers. Of course, this can in turn harm the economy.

Yet the rise in the dollar has come about because the US economy is in a relatively healthy state compared to its global neighbours. So actually, the negative impact of any slowdown in exports could easily be offset by an increase in confidence in the US economy, which may prompt more foreign investors to do business in the country.

It's also important to remember that a strong dollar makes imports cheaper, so companies that are able to purchase raw materials from abroad and outsource some of their operations to other countries may not struggle too badly after all.

Still, for several months now US companies have been accusing the greenback of harming their sales and profits, so it is clearly having an impact on the ground.

And of course cheaper imports can also have a negative effect, exerting downward pressure on prices and potentially bringing about deflation. While this can encourage consumer spending in some areas, it can also lead to economic stagnation as people hold onto their money in the hope that prices will fall further.

Deflation can also increase the real value of debt – making it more difficult for consumers and companies to pay off what they owe – and can bring about falling or stagnant wages which in turn can cause higher unemployment.

So the possible effects of a strong dollar on the US are quite complex. But what about the rest of the world? Well, foreign exporters obviously benefit as their goods are cheaper and therefore more attractive to US buyers. But it's not all good news.

The US dollar is the dominant international currency, so any upward movement can affect the entire global financial system. Back in December, when the currency was showing no signs of weakening, the Bank for International Settlements warned that it could contribute to an increase in the debt burden for emerging markets.

In recent years these markets have been taking on more and more dollar-denominated debt, and as the greenback rises it becomes increasingly difficult for them to service. If the US Federal Reserve moves to increase interest rates, as many suspect it will before the end of the year, emerging economies will be hit even harder.

So a strong dollar is most definitely a double-edged sword. The question remains, what is likely to happen to it going forward? Will it recover from the weakening it has experienced in the last few months and rise further, or is it on its way back down?

Many analysts and commentators think the greenback will continue to outperform other currencies in the global forex markets over the course of the next year. Indeed, with US interest rates expected to rise, possibly as early as September this year, the dollar could certainly enjoy a further boost

However, others think the currency has risen too high and that a correction may be on the cards. The International Monetary Fund said recently that the dollar was "moderately overvalued" and called on the Federal Reserve to delay a rate hike until next year. "Continued over appreciation is a potential risk and should not be discounted," said its managing director Christine Lagarde.

For now it is a wait and watch situation. What is clear is that whichever way the dollar goes, it will have far reaching consequences – some good and some bad – for consumers, companies and economies around the globe.

 

Image credit: iStock

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