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The U.S. dollar has been facing significant challenges recently, witnessing a decline that has had widespread implications for currencies globally. This downturn has caused a mix of relief and concern among central banks, as they navigate the effects of a weaker dollar.
In recent weeks, uncertainty surrounding U.S. policymaking has triggered a movement away from U.S. dollar assets and Treasurys, resulting in the dollar index falling more than 9% this year. Analysts anticipate further weakening of the dollar, with a recent Bank of America Global Fund Manager Survey revealing that 61% of participants expect a further decline in value over the next 12 months — marking one of the most pessimistic outlooks observed in nearly two decades.
This sell-off in U.S. assets may indicate a broader crisis in confidence, leading to potential issues such as increased imported inflation that could accompany a weaker dollar.
Adam Button, chief currency analyst at ForexLive, remarked that many central banks would welcome a 10%-20% decline in the dollar. Such a weakening could alleviate longstanding challenges related to the dollar’s strength, particularly for economies that maintain pegs to the dollar.
As the dollar depreciates, currencies such as the Japanese yen and Swiss franc have risen in value significantly. Since the year’s start, the yen has surged by over 10% against the dollar, while both the Swiss franc and the euro have seen increases around 11%, according to data from LSEG.
In addition to these safe havens, several other currencies have also strengthened, including the Mexican peso (up 5.5%), the Canadian dollar (appreciated over 4%), the Polish zloty (over 9% increase), and the Russian rouble (with an impressive gain of over 22%).
Conversely, certain emerging market currencies have not fared well despite the dollar’s overall weakness. The Vietnamese dong and Indonesian rupiah reached record lows earlier this month, while the Turkish lira recently hit an all-time low. The Chinese yuan faced a similar trend, plummeting to a record low versus the dollar but has since shown signs of recovery.
Breathing room to cut rates?
Analysts point out that a declining dollar offers a reprieve to many governments and central banks, although a few exceptions exist, such as the Swiss National Bank. Button emphasized that a weaker dollar is advantageous, especially for countries grappling with dollar-denominated debts, as it reduces the real burden of this debt. Moreover, when local currencies strengthen against the dollar, it may lead to cheaper imports, hence alleviating inflationary pressures. This scenario potentially grants central banks the flexibility to reduce interest rates to stimulate economic growth.
However, it is essential to note that while a stronger local currency can help control inflation by making imports less costly, it could simultaneously weaken export competitiveness — a critical consideration for economies like those in Asia, where the region is a major global goods producer.
Consequently, some emerging markets may begin to contemplate currency devaluation as a strategic response, particularly in Asia. Nick Rees from Monex Europe warned that managing the balance between devaluation and capital flight would be crucial for these nations.
Wael Makarem, financial markets strategist at Exness, indicated that the risks associated with devaluation are substantial. High inflation, debt levels, and potential capital flight complicate matters, making governments hesitant to take such measures. Additionally, any hints of currency devaluation could provoke U.S. retaliation.
Emerging market nations might be reluctant to lower interest rates given the implications this could have for domestic borrowers, particularly those with dollar-denominated debts. Alex Muscatelli from Fitch Solutions noted that while central banks might find some leeway in cutting rates, they must be cognizant of currency stability amidst volatility. Nations like Indonesia may limit rate reductions, whereas countries like Korea and India could possess more room for cuts.
The prevailing sentiment seems to be one of caution against initiating a currency war, which could exacerbate global economic instability.
In light of favorable conditions, the European Central Bank utilized declining inflation as an impetus to lower rates by an additional 25 basis points in April. The ECB highlighted that most underlying inflation indicators suggest convergence toward its medium-term target of around 2%.
In Switzerland, the strong franc has posed challenges that the Swiss National Bank has dealt with for years, as exports account for a significant portion of the nation’s GDP. Button noted that continued capital influx could compel the Swiss authorities to act decisively, especially amidst uncertainty when the franc becomes a more attractive safe haven.
Central banks are avoiding devaluation — for now
The prospect of currency devaluation weighs heavily on monetary authorities due to the potential for increased inflation. Brendan McKenna from Wells Fargo cautioned that while currency weakening is theoretically an option for foreign central banks, the current conditions make such actions unlikely.
Factors influencing a country’s capacity to devalue include the size of their foreign exchange reserves, exposure to foreign debts, trade balance, and vulnerability to imported inflation. McKenna stated countries with ample reserves and lower foreign debt reliance might find space for devaluation, although even those would proceed cautiously.
Ultimately, the outcome of trade negotiations significantly impacts how countries manage their currencies. While China has been less cooperative in negotiations, other nations have shown willingness to engage, which could mitigate tariff impacts and reduce the incentive for central banks to intentionally weaken their currencies. In the current geopolitical atmosphere, any currency devaluation risks provoking retaliation or accusations of manipulation.
Despite potential trade tensions leading to a more protective environment that might prompt some central banks to consider devaluation, the prevailing approach appears to prioritize stability over confrontation. McKenna succinctly concluded that avoiding a currency war is paramount to maintaining overall economic stability in both local and global contexts.
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