Over the last few months I have been hammering on the idea that the U.S. Dollar is a better gauge of risk in the global financial system than the so-called “Fear Gauge” – the CBOE Volatility Index (VIX). When on CNBC I have prefaced most of my equity market commentary with the view that as long the U.S. Dollar remains stable then the financial markets should remain calm. But if the U.S. Dollar rises, it creates risks to the global economy that are not captured by the VIX index.
U.S. Dollar’s Role in the Global Economy
To understand why this is so, we need to understand the role of the U.S. dollar in the global economy. Since WWII, the dollar has been at the center of the global economy serving as the “reserve” currency. Reserve currency status is both a burden and a privilege. It means that most currencies, commodities and debt are priced in U.S. dollars. It also serves as a reference currency for the majority of global trade. For a country, company or individual that does not hold U.S. Dollars they must first buy dollars before they can buy the raw materials needed to produce their product.
In its latest report on the Currency Composition of Foreign Exchange Reserves (COFER), the IMF reported that over 62% of foreign currency reserves are held in U.S. Dollars. The next closest currency is the Euro at a distant 20%. For all the talk of dethroning the dollar – it still remains King.
A Rising Dollar Reduces Lending to EMEs
What this and other IMF data tells us is that the U.S. Dollar is used as the base currency in international lending. In order to operate long supply chains – like building iPhones in China and shipping to the U.S.) – companies need working capital. This working capital is financed by global financial institutions and is denominated in U.S. Dollars. Herein lies the rub. What the IMF has found is that as the dollar rises, global financial institutions lend less to emerging market economies (EMEs). This reduction in lending has a negative impact on real investment in the EMEs.
At this point, some might push back and argue that a weak currency in a net export country is positive for that country’s economy since its goods will be cheaper to foreign buyers. However, the IMF study shows that the diminished credit and the resulting slowing of real investment outweighs the positive effect of a weak local currency. This starts a negative feedback loop. As the U.S. Dollar rises – or local currency falls – banks curtail lending; this leads to a slower economy, which leads to increased default rates on bank loans. Banks respond by reducing credit and a deleveraging cycle ensues.
U.S. Federal Reserve’s Impact on the Dollar
While the Federal Reserve will tell you that value of the U.S. Dollar is the concern of the U.S. Treasury – the Fed’s actions have a profound impact on its value.
When the Federal Reserve lowered interest rates below zero with Quantitative Easing it made borrowing money virtually free. Investors borrowed money at low rates in the United States and then invested in countries with higher interest rates. This fueled the economic expansion of EME’s. QE also had the side-effect of weakening the U.S. dollar, which as the IMF has shown increases lending by banks to EME’s. This influx of capital creates a boom. But when that flow reverses it ushers in the inevitable bust. This is what we are currently seeing in countries like Argentina, Brazil, and Turkey.
We have all heard of the trillions of U.S. dollars parked in foreign bank accounts by the like of Apple. The primary reason these profits has not flowed back into the U.S. is because of taxes. Apple (and other U.S. companies) pay a reduced tax rate on international profits that are kept in foreign banks. But there is another reason.
U.S. corporations has been able to borrow money at extraordinarily low rates. At the same time, they lend out the profits at foreign banks at much higher rate of return. This form of financial alchemy is known as a carry trade.
But now U.S. corporations have both an economic and political incentive to repatriate dollars. The weaker EMEs create more risk to lending while the U.S. government has reduced taxes on foreign profits. This accelerates the dollar appreciation and emerging market currency decline.
As investors bring those invested dollars home, the local currency falls and credit is curtailed. And the deleveraging bust ensues.
The higher the dollar goes the more risk of a global deleveraging. Said another way the U.S. dollar is the new VIX.
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