By Obiyathulla Ismath Bacha
The elevenfold increase in interest rates by the Fed caused the US dollar to appreciate sharply against just about every other currency and the resulting squeeze led to the current complaints
It was late 1971 and developing nations had been complaining vehemently about how the US dollar’s dominance and appreciation was hurting them. Responding to these complaints, then US treasury secretary John Connally shocked the world when he famously said, “The dollar is our currency, but it’s your problem”. Such was the hubris. The attitude was quite simply: I lead but you pay! Fast forward to 2024, and more than 50 years later the complaint is exactly the same. Developing countries are being squeezed yet again by a dollar that has risen sharply due to rapid increases in US interest rates. The US Federal Reserve raised its key policy rate from 0.5% to 5.5% within a short period to fight inflation. The elevenfold increase in interest rates caused the greenback to appreciate sharply against just about every other currency and the resulting squeeze led to the current complaints.
Who do we blame for this unchanged state of affairs over the last 50-plus years? US unilateralism in responding to its own needs or policy inaction among developing nations to seriously de-dollarise? Throughout the last 50-plus years, as the dollar’s vagaries played havoc with their economies, there has been much hand wringing and talk about the need for developing nations to de-dollarise. But beyond the talk, there has been little action. The much-hyped bilateral payment arrangements cannot effectively de-dollarise as domestic exporters are forced to accept payment in a much less liquid but more volatile currency than the dollar. Thus, exporters would have little motivation to play the bilateral payments game. And so, we end up seeing the same movie again and again.
The dollar’s rise this time has not only been rapid but broad based. It is said to have risen against at least two-thirds of the world’s 150-plus currencies. It has also risen against all 30 of the most actively traded emerging market currencies. Within Asia, the yen, won, ringgit, Indian rupee, Taiwan dollar and Philippine peso are all at multi-year lows. The yen has fallen 12% over the first four months of this year. The Fed rate hikes began in mid-2022 and having plateaued in August 2023, market expectation was for a decline beginning this year, with a first cut expected in March 2024. Expectation for the inevitable rate cuts was so entrenched that US stocks and bonds were priced to perfection and Asian central bankers did little more than hold their breath, awaiting relief. Unfortunately, inflation just wasn’t cooperating. With the US economy, consumption and corporate profits continuing to boom, thanks to the massive post-Covid stimulus, inflation seems nowhere near declining to the Fed’s targeted 2%. With US interest rates looking to remain higher for longer, Asian and emerging market currencies are likely to be in the doldrums a lot longer.
For developing countries, a rising US dollar brings a multitude of problems. It alters the nation’s terms of trade and increases the price of imports. And if the nation imports foodstuff and other basic items, imported inflation can result. On the export side, with most developing countries being commodity exporters and therefore price takers, they benefit little from a depreciation of the home currency. This asymmetric impact on the trade balance automatically worsens the current account and causes balance of payments problems. For countries with US dollar-based borrowings, the liability and debt burden increases in home currency terms. Further, the capital flight incentivised by the negative interest spread can potentially erode foreign reserves. Thus, a country’s fundamentals can deteriorate very quickly and macro-economic vulnerability increases substantially.
So, what can a developing nation do to protect itself? The answer is, not much. The quickest and most effective way to neutralise the situation would be to raise domestic interest rates to match the rise in US rates. Unfortunately, this is not an option as most developing nations, addicted to debt-fuelled growth and pandemic-related expenditure, are now up to their necks in debt. When a domestic economy is highly leveraged, raising interest rates would be excruciatingly painful. Growth gets choked, domestic investments are stifled, consumption is restricted and the household sector is squeezed by higher debt servicing. Unchecked, bad loans rise and banks begin to wobble. Thus, the most effective policy tool, the interest rate option, is just not doable from either an economic or political viewpoint. That leaves central banks with peripheral choices like requiring quicker remittance of export proceeds, placing impediments on outflows and lots of jawboning — pleading, screaming, threatening.
The fact is, there is not much that a developing nation can do unilaterally, but much that can be done collectively. Just as a group of individuals locking hands have a much better chance of making it across a river with strong currents, where an individual cannot, this long-standing problem of US dollar dominance cannot be solved by nations acting alone. Consider the fact that the Philippines, Taiwan and Indonesia had all raised interest rates recently and yet saw their currencies fall further against the dollar. Mighty Japan had both raised rates and intervened heavily, reportedly using up US$59 billion of its reserves within a week, yet the yen sank further. The point is, unilateral action in these circumstances can be hideously expensive and always ineffective in the long run. A more sensible route for developing countries to consider would be a collective Regional Currency Arrangement (RCA).
An RCA would not just help to de-dollarise but offers other benefits like enhanced trade and economic integration, exchange rate stability and reserves management. Where no one currency can now stand up to the dollar’s vagaries, a composite regional currency anchored on the combined resources of member countries should be able to offer more resistance. Broadly speaking, RCAs can range from a Common Currency Area (CCA) or currency union with fixed pegs to looser, target zone type arrangements. The eurozone and WAMU (West African Monetary Union) would be examples of the former while the EMS (European Monetary System), forerunner to the euro, is an example of a target zone arrangement. The EMS, established in 1979, enabled the 12 participating countries to reduce inflation, stabilise their currencies and enhance trade and economic integration. Yes, it had its problems but over the 20 years until 1999, it enabled the countries to integrate and evolve into a single currency area. At the heart of the EMS was the European Currency Unit (ECU), which was simply a statistical GDP weighted composite currency. Under the exchange rate mechanism, each participating currency was linked to the ECU at a fixed rate. However, to avoid a fixed peg and the policy restrictions that come with fixed pegs, currencies were allowed to fluctuate within a band. The band, first set at 2.25%, was later raised to 6% and then 15%. The flexible bands enabled participating countries to benefit from the stability afforded by the RCA without sacrificing all their economic sovereignty. Fixed peg, monetary union type arrangements would certainly provide more intra-regional currency stability but the policy restrictions it requires can be debilitating.
It is an RCA with flexible arrangements designed on the EMS target-zone template that Asian developing nations should aim for. There is no reason why Malaysia, Indonesia, Thailand and Vietnam, for example, should not initiate work on an ECU style Asean currency. Despite the flexibility, the policy conformity that such an arrangement requires imposes discipline on participating governments and it is such enforced discipline that gives it credibility and gains the trust of currency markets. An RCA is no quick fix, it has its own set of challenges. However, for nations with little choice but being sitting ducks, it offers a viable long-term solution to better manage their economic destiny. Unless there is serious action towards some collaborative currency arrangement, the complaints over the last 50 years, of the dollar’s evils, could likely continue into the next 50.
Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF University
This article first appeared in Forum, The Edge Malaysia Weekly on May 13, 2024 – May 19, 2024 (https://theedgemalaysia.com/node/711273)
