Reasons Behind the Appreciation of the Dollar

Written by Vanshita Chandwani

Despite U.S. being one of the countries that was worst hit by the global pandemic, including the fact that the U.S. stock markets hit the lowest record amidst an economic shut-down, dollar continues to escalate. This escalation of dollar is a simple indicator of its excess demand over its supply. But why is the dollar on the rise?

Investment in the U.S. is one of the safest reserves that yield a high rate of return on the investment, and in moments of uncertainties, investors withdraw their investments from other countries and reallocate those funds in the U.S. market, making the dollar currency rise, even when all other currencies start devaluing.

People also choose to store their wealth in dollar as opposed to any other currency.

Countries and economies also to choose to maintain healthy reserves of dollar as it is used in International trading. In the face of adversities, as is the case now, each country tries to increase its reserve of dollar which leads to an increase in the demand for dollar.

All trade deficit (excess imports over exports) caused by the import of consumer goods is offset by the foreign capital that the U.S. acquires in the form of Foreign Direct Investments and Foreign Portfolio Investments.

Most of the foreign bank reserves are in U.S. bonds. A very large percentage of the world’s debt is also denominated in dollars, which helps the dollar maintain its strength in the world market even during times of crisis.

Countries like China and Japan are on the constant look-out to purchase U.S. Treasury bonds to keep the exchange rate of dollar high for the sake of their export-driven economy. The payments for these are made in dollars which increases foreign capital. Therefore, developing countries and evolving economies have a very high demand for dollars.

The dollar also possesses the characteristic of wide acceptability.

For example, Panama, El Salvador, and Ecuador use dollar as legal tender with a lack of local currency, while Cambodia and Lebanon use dollar and their local currency interchangeably.

A lot of private transactions in various MNCs are also carried out in dollars. In a time like today everything that can be sold is being sold against the dollar. All of these stakeholders hold large reserves of dollar, and their demand for it constantly increases.

Non U.S. investors would like to invest in U.S. corporate stocks rather than those based in any other company. The 2.3 trillion dollar injection of the government has reassured investors that the economy will bounce back.

It is an initiative to keep businesses running. High unemployment rates also imply that the government will be under political pressure to keep businesses running to avoid further mass retrenchment, which could potentially mean more support from the government and the U.S. Treasury.

The truce between Saudi Arabia and Russia to reduce the production of oil has created the much needed artificial scarcity of oil in the market to push the plunged prices of oil back up, which is again good news for the American oil exporter.

The Euro, along with the a few other strong currencies, has also faced a hit, which has made the USD stronger automatically. The foreign assets of all other countries are declining while they rise for the States. The Fed has put in efforts to reduce the attractiveness of dollar-denominated markets by cutting the interest rates, but the demand for dollar does not seem to dissipate. This hints at the favorable sentiment and market psychology of the investor towards the dollar.

The geopolitical risk is seen as very low, which precipitates concern. This could impede a fast global economic recovery after the slowdown of the pandemic. These trends imply that the global demand for goods will remain low. The usual will follow.

Production will reduce, leading to laying off of workers and a reduced income level which would imply a further reduction in demand. The vicious cycle will continue. This would also take a toll on American exporters.

US multinational companies that dominate the world market would come under threat, not only by the decline in demand by the global pandemic, but also by the surge in dollar making their products lesser competitive in the global market. As a result of the resurgent dollar, the financial cost of production may also rise. COVID-19 has highlighted the issue of the global dominance of and reliance on dollar. In this time of crisis, in the state of an almost global shut-down, transactions need to be made in dollars and sources of that funding have become scarce. Emerging markets have had all their investments sucked out which is not a positive sign in terms of economic recovery. What could be some potential outcomes of this?

This could force countries to form an alliance to prop their own currencies up.

Kathy Lien, managing director of FX strategy at BK Asset Management, adds on this with his analytical predictions.

“The main risk for the dollar is G7 currency intervention. With the rise in the greenback driving many currencies to multi-year lows, central banks from Brazil to Norway have rushed to prevent further losses.”, said Kathy Lien
“There's a very good chance that coordinated action on a global scale will be next. If they come into the market, it will be to sell dollars, not buy them.”

A basket currency (a portfolio of selected currencies to avoid over-reliance, over-dominance, over-burdening, and fluctuations of a single currency) is proposed by few economist because it seems to be better equipped to handle tremors like the current one.

While the dollar seems to have an overall dominance in the current market, make sure to stay indoors to help globally dominate the virus.

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