The dollar is everyone’s problem

CAMBRIDGE — In 1971, US treasury secretary John Connally famously told his counterparts in the G10 that “the dollar is our currency, but it’s your problem”. Connally was being unexpectedly candid about the fact that, even though the greenback was the world’s main reserve currency, its foremost purpose was to advance US interests.

That remains true today. But in recent decades, the dollar’s central role in global trade and finance has posed more of a problem for emerging-market and developing economies (EMDEs) than for the world’s rich countries. For example, the US Federal Reserve’s (Fed’s) current tightening cycle, like others before it, has disproportionately affected EMDEs by fuelling massive and inordinate capital outflows. This, in turn, has triggered currency gyrations that exacerbate macroeconomic challenges and increase debt-servicing costs, resulting in limited fiscal space for public investment.

Recent monetary-policy divergences between the Fed and other advanced-economy central banks are, however, stoking exchange-rate volatility in the world’s rich countries. The spillovers from the Fed’s higher-for-longer policy position are perhaps most pronounced in Japan, which has recently taken to intervening in foreign-exchange markets to stem the yen’s rapid slide.

In June, the US Treasury added Japan to its “monitoring list” for potentially unfair foreign-exchange practices. Although the Treasury stopped short of designating Japan as a currency manipulator, which could have resulted in the US imposing sanctions on one of its staunchest allies, the move was significant, not least because it highlighted the global risks of monetary-policy divergence and the inherent challenges of international coordination on this front.

Japan made the monitoring list because it met two of the three criteria that the Treasury uses to assess the policies of major US trading partners, specifically, a trade surplus with the US of at least $15 billion, and a current-account surplus above 3 per cent of GDP. The third criterion is persistent, one-sided intervention in foreign-exchange markets, with net purchases totaling at least 2 per cent of GDP over 12 months. The Treasury report to Congress noted that while Japan has not reached that threshold, it has aggressively intervened in foreign-exchange markets.

Japanese authorities have indeed spent billions of dollars to prop up the yen, which has lost a third of its value since 2021 and fell to a 34-year low of more than 160 per dollar in April. This is largely because of the yawning interest-rate differential between the two countries: When the Fed sharply raised interest rates in early 2022 to combat inflation, the Bank of Japan maintained its negative interest-rate policy to address domestic deflation. In its report, the Treasury emphasised its expectation “that in large, freely traded exchange markets, intervention should be reserved only for very exceptional circumstances with appropriate prior consultations”.

Most notably, the Japanese authorities spent a record ¥9.8 trillion ($61.2 billion) in April and May to reverse the yen’s downtrend, surpassing the total amount deployed to defend the currency in 2022. Despite the scale of these efforts, the yen’s descent continued, illustrating the challenges of defending a plunging currency in a highly integrated global financial system.

For months, investors have increasingly turned to carry trades, which involve borrowing in yen to invest in higher-yielding assets abroad. This, combined with rising bond yields, puts downward pressure on the yen. Moreover, the currency’s depreciation has discouraged exporters from converting foreign earnings into yen due to heightened exchange-rate risks, further decreasing demand and reinforcing yen weakness.

In July, the Japanese government spent $36 billion on yet another yen-buying effort — its third intervention of the year. Citigroup estimates that the country has $200-300 billion in financial reserves for any such campaign, which could entail selling dollars, other currencies, or even government bonds to support the yen and mitigate economic damage.

Ordinarily, monetary authorities will intervene to weaken the local currency to boost exports and enhance competitiveness. The 1985 Plaza Accord, which led to the yen appreciating 46 per cent against the dollar, did just that for the US, but diminished Japan’s competitiveness, prompting Japanese automotive companies to establish factories in America.

The unusual steps recently taken by Japan’s monetary authorities instead reflect the high costs of monetary-policy divergence for global stability and growth. While the weak yen has boosted inbound tourism and exports to the US, it has also led to excessive exchange-rate volatility, dampening corporate investment and raising costs for industry and importers. Private consumption, which accounts for more than half of the Japanese economy, has slowed, increasing the risk of stagflation. As a result, the Japanese government has revised downward its growth forecast for the current fiscal year (ending March 2025) from 1.3 per cent to around 0.9 per cent.

Some signs point to the interest-rate differential narrowing and the yen stabilising. In the second half of July, the yen strengthened against the dollar by 4 per cent and rallied to its strongest level since March the day after the BOJ raised its benchmark interest rate to 0.25 per cent. The yen’s surge followed milder US inflation data in June and a softer labor market in July, both of which could lead the Fed to cut rates sooner as it shifts from a single-minded focus on the inflation target to the dual mandate of price stability and maximum employment in the face of a renewed threat to growth.

But this new period of policy divergence among systemically important central banks has underscored the greenback’s enormous global impact. When these monetary authorities moved in sync, it was easy to view the US currency as an issue only for EMDEs. Japan’s recent currency stress, though, serves as a stark reminder that the dollar is a problem for rich and poor economies alike.

Hippolyte Fofack, a former chief economist and director of research at the African Export-Import Bank, is a Parker fellow with the SDSN at Columbia University, a research associate at the Harvard University Centre for African Studies, a distinguished fellow at the Global Federation of Competitiveness Councils, and a fellow at the African Academy of Sciences. Copyright: Project Syndicate, 2024.

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