Why a Strong Dollar Could Mean a Debt Crisis

The average household in Ghana pays two-thirds more than last year for diesel, flour and other necessities. In Egypt, wheat is so expensive that the government has missed half a billion dollars from its budget for a bread subsidy it pays to its citizens. And Sri Lanka, already struggling to control a political crisis, is running out of fuel, food and medical supplies.

A strong dollar makes the problems worse.

Compared to other currencies, the US dollar is the strongest it has been in two decades. It is rising because the Federal Reserve has raised interest rates sharply to fight inflation and because America’s economic health is better than most. Together, these factors have attracted investors from around the world. Sometimes they just buy dollars, but even if investors buy other assets, like government bonds, they need dollars to do so, which drives up the value of the currency in each case.

This strength has become a large part of the world’s weakness. The dollar is the de facto currency of global trade, and its sharp rise is squeezing dozens of low-income countries, mainly those that rely heavily on food and oil imports and borrow in dollars to finance them.

“We live in a world with small fires everywhere,” said Mohamed El-Erian, president of Queens’ College, part of the University of Cambridge, and former chief executive of PIMCO, the bond manager of 2 trillions of dollars. “If we’re not careful, these small fires could become much larger.”

Rising food and energy prices resulting from the war between Russia and Ukraine were already hurting some emerging countries. The rise of the dollar, whose strength is measured against a basket of currencies representing America’s major trading partners, has exacerbated these problems by making it even more expensive to import vital goods using weaker currencies.

A strong dollar forces countries to use more of their own currency to buy the same amount of goods. This higher price means they are inadvertently importing more inflation with their grain and fuel. And because they borrow in dollars, they have to pay interest in dollars, which adds to their financial distress.

Some countries are already in default. Others are on the edge of the abyss. A sovereign debt crisis could soon spread, derailing the fragile post-pandemic recovery and amplifying the likelihood of a severe global downturn.

“Things are looking a bit shaky right now,” said Leland Goss of the International Capital Markets Association, a trade body. “There seems to be a consensus that we may be facing for the first time in a while, not one but a whole set of countries going into restructurings.”

Four emerging countries have defaulted on their debts so far this year, according to S&P Global Ratings – Russia, Sri Lanka, Belarus and Ukraine. Ten others are in “severe stress” – Argentina, Lebanon, Ghana, Suriname, Zambia, Ethiopia, Burkina Faso, Republic of Congo, Mozambique and El Salvador, according to the rating agency. Of the 94 emerging market sovereign debt funds rated by S&P around the world, more than a quarter are rated B-minus or less, a low-quality rating indicating a high-risk investment.

The grim situation is part of the collateral damage of Russia’s war with Ukraine and the Fed’s fight against inflation, and it highlights the global connections that have left the fates of countries around the world inextricably linked. decisions taken in Moscow and Washington.

“We are in a fragile situation,” Mr. El-Erian said. “One country after another is flashing orange, and some are already flashing red.”

Many low-income countries were already struggling during the pandemic.

About 22 million people in Ghana, or a third of its population, reported a drop in income between April 2020 and May 2021, according to a survey by the World Bank and UNICEF. Adults in almost half of households with children surveyed said they skipped a meal because they didn’t have enough money. Almost three-quarters said prices of major food items had risen.

Then came the invasion of Ukraine by Russia. The war between two of the world’s biggest exporters of food and energy has led to a sharp spike in prices, especially for importers like Ghana. Consumer prices rose 30% on the year to June, according to data from research firm Moody’s Analytics. For basic necessities, annual inflation has reached 60% or more this year, according to S&P data.

To illustrate this, consider the price of a barrel of oil in dollars against the Ghanaian cedi. At the beginning of October last year, the price of oil stood at $78.52 a barrel, rising to nearly $130 in March before falling back to $87.96 at the start of this month, a one-year increase. year of 12% in dollars. Over the same period, the Ghanaian cedi has weakened by more than 40% against the dollar, meaning that the same barrel of oil that cost around 475 cedi a year ago now costs over 900 cedi, almost double.

Adding to the problem are large state-funded subsidies, some of which were taken or increased during the pandemic, which are now straining public finances.

Ghana’s president cut fuel taxes in November, losing around $22 million in projected government revenue – the latest figures available.

In Egypt, spending on what the government calls “commodities,” almost all of which is wheat for its longstanding bread subsidy, is expected to account for around 7% of all government spending this year, that’s 12% more – or more than half a billion dollars – than the government’s budget.

As costs soared throughout the pandemic, governments took on more debt. Ghana’s public debt has risen to nearly $60 billion from around $40 billion at the end of 2019, or nearly 80% of its gross domestic product from around 63%, according to Moody’s.

It is one of four countries listed by S&P, alongside Pakistan, Nigeria and Sri Lanka, where interest payments alone account for more than half of government revenue.

“We can’t forget that this is happening at the end of a once-in-a-century pandemic in which governments, to try to support families as best they could, borrowed more,” said S&P analyst Frank Gill. “It’s a shock that follows another shock.”

In May, Sri Lanka defaulted on its public debt for the first time in its history. Over the past month, the Egyptian, Pakistani and Ghanaian governments have all requested bailouts from the International Monetary Fund as they struggle to meet their debt financing needs, no longer able to turn to international investors for more funding. ‘silver.

“I don’t think there’s a lot of appetite to lend money to some of these countries,” said Brian Weinstein, co-head of credit trading at Bank of America. “They are incredibly vulnerable right now.”

This vulnerability is already reflected in the bond market.

In 2016, Ghana borrowed $1 billion over 10 years, paying an interest rate of just over 8%. As the country’s financial situation deteriorated and investors recoiled, the yield – indicative of what it would cost Ghana now to borrow money until 2026 – exceeded 35%.

This is an unsustainable cost of debt for a country in Ghana’s situation. And Ghana is not alone. For bonds that also mature in 2026, Pakistan’s yields have reached almost 40%.

“We have concerns when a country has returns that call into question its ability to refinance itself in public markets,” said Charles Cohen, deputy division chief of the IMF’s monetary and capital markets departments.

The risk of a sovereign debt crisis in some emerging markets is “very, very high,” said Jesse Rogers, economist at Moody’s Analytics. Mr Rogers compared the current situation to the debt crises that crushed Latin America in the 1980s – the last time the Fed sought to stifle runaway inflation.

Already this year, more than $80 billion has been withdrawn from mutual funds and exchange-traded funds — two popular types of investment products — that buy emerging market bonds, according to data provider EPFR Global. . When investors sell, the United States is often the beneficiary, which further strengthens the dollar.

“This is by far the worst year for exits the market has ever seen,” said Pramol Dhawan, head of emerging markets at PIMCO.

Even citizens of some of these countries are trying to exchange their money for dollars, fearing what is to come and further depreciation of the currency – but also inadvertently contributing to it.

“For pockets of emerging markets, this is a really tough backdrop and one of the most challenging backdrops we’ve faced in many years,” Dhawan said.