Uncertainty over US policy has led to a flight from the dollar and US bonds, with the dollar index down more than 9% so far this year. The dollar’s decline has led to other currencies appreciating against it, notably safe havens such as the Japanese yen, the Swiss franc and the euro.
Currency depreciation is likely to be a major issue in emerging markets, particularly in Asia, as emerging markets face high inflation, debt and capital flight risks, making devaluation dangerous.
The dollar’s decline
The dollar has weakened and the knock-on effect on other currencies has brought a mix of relief and headaches to central banks around the world. Uncertainty over US policy has led to a flight from the dollar and US bonds in recent weeks, with the dollar index down more than 9% so far this year.
Trust Economics predicts further declines. Specifically, it predicts a decline in the value of the dollar over the next 12 months. The flight from US assets may reflect a broader crisis of confidence, with potential consequences such as increased imported inflation as the dollar weakens.
The dollar’s decline has led to an appreciation of other currencies, notably safe havens such as the Japanese yen, the Swiss franc and the euro. Since the beginning of the year, the Japanese yen has gained more than 10% against the dollar, while the Swiss franc and the euro have both gained about 11%, according to LSEG data.
Aside from safe havens, other currencies that have gained against the dollar this year include the Mexican peso, which is up 5.5% against the dollar, and the Canadian dollar, which has gained more than 4%.
The Polish zloty has gained more than 9%, while the Russian ruble has gained more than 22% against the dollar. However, some emerging market currencies have depreciated despite the dollar’s weakness.
The Vietnamese dong and the Indonesian rupiah fell to record lows against the dollar earlier this month. The Turkish lira also hit a record low last week. The Chinese yuan hit a record low against the dollar about two weeks ago but has since strengthened.
Is the “breather” needed to cut interest rates?
With a few exceptions, such as the Swiss National Bank, the weakening dollar has been a relief for governments and central banks around the world.
Most central banks would be happy to see the dollar fall by 10%-20%. The strength of the dollar has been a persistent problem for years, causing difficulties for countries with tight or loose links to the dollar. With many emerging markets carrying large amounts of dollar debt, a weaker dollar reduces the effective burden of the debt.
In addition, a weaker dollar and a stronger local currency tend to make imports relatively cheaper, reducing inflation and allowing central banks room to cut interest rates to boost growth.
The recent decline in the dollar provides more breathing space for central banks to cut interest rates. While a stronger local currency can help curb inflation through cheaper imports, it complicates export competitiveness, especially under renewed U.S. tariffs, which expose Asia as the world’s largest producer of goods.
Currency devaluation is likely to be a hot topic of discussion in emerging markets. However, central banks in these emerging markets and Asia will have to walk a tightrope to avoid capital flight and other risks.
Emerging markets face high inflation, debt, and capital flight risks, making devaluation risky.
In addition, devaluation could be viewed by the U.S. government as a trade measure that could provoke retaliation.
Emerging market economies may be reluctant to cut interest rates, as this could affect the debt burden of domestic households and businesses that have borrowed in dollars.
A weaker domestic currency may also lead to capital outflows due to lower interest rate differentials with the US.
South Korea and India may have room to cut rates.
The European Central Bank seized the opportunity presented by falling inflation and cut interest rates by 25 basis points at its April meeting.
The ECB said on Thursday that “most measures of underlying inflation suggest that inflation will stabilise around the Executive Board’s 2% objective over the medium term.”
Another example is the Swiss National Bank, which has struggled with a strong franc for much of the past 15 years.
Exports of goods and services account for over 75% of Switzerland’s GDP, and a strong franc makes Swiss goods more expensive abroad.
If capital flows continue, they may be forced to take drastic measures to devalue the currency. Investors flock to the franc in times of uncertainty, such as in recent weeks, strengthening the franc.
Central banks avoid devaluation — for now
Currency depreciation carries the risk of fueling price growth, and monetary authorities will be careful not to let inflation exceed their targets.
The risk of higher inflation from currency depreciation, as well as tariffs — as countries react to U.S. tariffs — is likely to make central banks reluctant to pursue the path of voluntary devaluation.
Furthermore, while most foreign central banks theoretically have the ability to weaken their currencies, the likelihood of doing so is still low in the current environment, Trust Economics adds.
Whether a country can devalue its currency depends on several factors:
- the size of its foreign exchange reserves,
- its exposure to foreign debt,
- its trade balance, and
- its sensitivity to imported inflation.
Export-oriented countries with ample reserves and lower reliance on foreign debt will have more room to devalue – but even they will likely proceed with caution.
The broader direction of trade negotiations will determine how countries act. In addition to China, many countries have shown a willingness to engage in trade negotiations, and if those talks lead to lower tariffs, central banks will be less likely to follow suit, Trust Economics said in its analysis.
In the current geopolitical climate, devaluation could also trigger retaliation and create risks for currency manipulation charges.
Although there is still a possibility that trade tensions could lead to more protectionist developments, which would prompt central banks to devalue their currencies.
For now, it seems the preferred course of action is to avoid a currency war that would add more volatility to the local and global economy, Trust Economics said in its report.
