[Insight & Opinion] The Dollar's Extreme Strength and the Potential for Contagion in Global Financial Markets

The dollar's extreme strength continues amid concerns that the U.S.'s aggressive tightening will persist through next year. The dollar index, which reflects the exchange rate between the dollar and six major currencies including the euro, approached 115. Our foreign exchange market also fluctuated wildly, with the won-dollar exchange rate soaring well past 1,400 won, levels seen during past foreign exchange and financial crises. Emerging countries in South Asia are facing a wave of bankruptcies due to currency value collapses and increasing external debt burdens. This is a consequence of the Federal Reserve (Fed) and major central banks accelerating interest rate hikes to curb inflation.

Since it will take considerable time for inflation in major advanced countries to fall to the 2% range, attention is focused on how long emerging countries with depleted foreign exchange reserves can endure. Some recall a d?j? vu of the 1997 Asian financial crisis. Pakistan, which reapplied for bailout funds this year, and Bangladesh, whose garment industry is in crisis, have turned to the International Monetary Fund (IMF) for assistance. Sri Lanka, in a worse situation than these countries, negotiated with China after its government collapsed and it became difficult to meet IMF aid conditions. They are paying the price for having borrowed dollars at low costs over ten years and spending them freely.

Myanmar is also classified as a country at risk of contagion. Since the military coup in February 2021, it has faced difficulties due to various sanctions and foreign capital flight. The value of Myanmar’s currency, the kyat, against the dollar has plummeted, and inflation is severe. Laos is also facing serious debt problems, with concerns emerging that it may declare default. Consider 2018, when the U.S. raised interest rates, causing an inversion of short- and long-term rates and a rate inversion between Korea and the U.S. At the core of emerging market economic crises then were Argentina and Turkey. Argentina raised its benchmark interest rate to an extraordinary level to prevent capital outflows, but the Argentine peso’s value halved.

The IMF decided to provide a record $57.1 billion in support to prevent the Argentine crisis from spreading to international financial markets. Turkey refused IMF bailout funds and sought help from China and Russia. At that time, not only Argentina and Turkey but also Brazil, South Africa, Pakistan, Indonesia, and India were classified as at-risk countries. Several emerging market governments raised benchmark interest rates one after another to prevent currency outflows. Fortunately, the contagion risk was contained in 2019 when the U.S. cut interest rates.

What do the current South Asian crisis countries and Argentina and Turkey have in common? All have severe accumulated government debt due to prolonged fiscal deficits. Another characteristic is excessive reliance on issuing foreign currency bonds to cover fiscal deficits. These factors have created a complex crisis, and if it spreads globally, the world could face a systemic crisis. Systemic risk refers to a situation where various variables such as exchange rates and stock prices fluctuate wildly, causing serious ripple effects on the real economy and the financial system ceases to function normally, as seen during the foreign exchange crisis. In September, Serbia in Europe began discussions with the IMF for fiscal support following a sharp rise in government bond yields.

Suddenly recalling the European fiscal crisis, one wonders if countries like Italy, Spain, and Portugal are free of problems. The European Central Bank (ECB) raised its benchmark interest rate in line with U.S. rate hikes. Italy, already with low fiscal soundness, saw its borrowing costs soar tremendously. The ECB must be mindful of the high volatility in Italy’s government bond market amid its tightening stance. If the bond markets of fiscally vulnerable countries show unstable movements, the ECB should actively respond through various bond purchase measures. When difficulties arise in the global economy, the importance of national credit ratings, foreign exchange reserves, fiscal soundness, maintaining current account surpluses, and the global financial safety net comes to mind.

Jo Won-kyung, Professor at UNIST / Director of the Global Industry Cooperation Center