The U.S. President-elect Donald Trump's statements on the economy have brought expectations of a warmup for the U.S. economy. At the same time, the recovery and warm-up of the economic activity brings the risk of inflation with it. Another expectation triggered by this is that the Federal Reserve (Fed) can realize higher-than-anticipated increases in the interest rates in 2017. Even the discussion of these possibilities has resulted in a rally for the U.S. dollar in global markets. It is not common for the dollar to increase 3 percent in value against other currencies in 16 days. The appreciation of the dollar creates serious risks for the U.S. economy in the middle and long term.
Considering that the recovery of the U.S. economy is still fragile, the economic policies of Trump's team's will push the Fed for a more rapid increase in interest rates and might bring a series of economic distress with it. More interestingly, the U.S. has surpassed Germany in exports for the first time since 2011 and since then it has maintained its position as the second in the world's goods trade, which means a strong dollar will no doubt result in serious trouble for U.S. exporters. It is a fact that Trump has called companies, specifically Apple, that manufacture their products outside the U.S., to bring their productions to America. However, the strengthening of the dollar, mainly for American companies and notably in terms of labor cost, will bring great trouble with the rising cost of manufacturing on U.S. soil. Furthermore, it will negatively affect the competitiveness of American exporters.
Dollar-based indebtedness will be an issue
The fact that the European banks are going through a tough period has limited borrowing in terms of the euro. That's why, in 2015 and 2016, both states and companies have predominantly made their borrowings in dollars. Today, the risk of a "strong dollar" brings along a series of questions for these countries in terms of managing debt. The rollover of dollar debts will become more expensive in the upcoming period. Excluding the U.S., the Bank for International Settlements (IBS) points to close to $10 trillion of debt in the global economy. Around $3.3 trillion of this amount represents the debt of institutions and companies in developing countries. A strengthening dollar will pose three crucial complications for these developing nations.
First, the rapid devaluation of the currencies of developing nations against the dollar will require them to create larger funds in their local currencies and a higher value creation for the dollar debts to be rolled over. However, at the same time, the central banks of these countries will be increasing the interest rates to prevent the devaluation of the local currencies. This will both raise the cost of resources in terms of local currency and will adversely affect the growth performance of the developing country. Thus, their problem of paying dollar-denominated debts will get even more challenging.
The second issue will present itself as increasing the cost of debt in dollars in developing nations. A strong dollar will directly affect credit conditions. When considering that banks in developing countries borrow in terms of dollars and lend to companies in terms dollars, the dollar-denominated credits will become excessively costly. As this circumstance will diminish the attractiveness of loans in dollar terms, it will negatively affect loans for both projects and exports and will slow down economic activities.
Fed can get stuck
The third issue the strengthening dollar will cause, with the depreciation of the local currency against the dollar, will be the extreme demand for the dollar from companies to immediately pay their previously debts taken in dollars. This will cause the already weakened local currencies against the dollar to depreciate even more against the dollar. Companies, at the cost of paying their debt in dollars, will have to use extremely expensive loans in local currencies. This will negatively affect both investments and employment in developing countries.
The fact that Trump's policies are strengthening the U.S. dollar is seen as an increase in the costs of growth and financial resources in the global economy. In this case, the Fed will either raise the interest rates in relation to the rising inflation risk within the U.S. economy and will cause the stagnancy in the global economy to intensify, or announce a limited rate hike not to deepen the troubles in the global economy despite the rising inflation risk within the U.S. economy. In both cases, the Fed has a tough task to overcome.
About the author
Kerem Alkin is an economist, professor at Istanbul Medipol University. He currently serves as the Turkish Permanent Representative to the Organisation for Economic Co-operation and Development (OECD).