The US dollar is rising in relation to the other currencies of the world’s large economies. Its appreciation is casting shadows on the global economy and on the Egyptian economy as well. People around the world are concerned about the repercussions of global events and the decisions of the US central bank, the Federal Reserve, on them and about the effects these have on their daily lives in terms of commodity prices and standard of living.
The fate of the Egyptian economy is tied to the direction of the US dollar. Over the past few months, people in Egypt have been concerned about the effects of US interest rates on the Egyptian economy and of the (partial and managed) devaluation or floating of the Egyptian pound. The exchange rate has risen to more than LE18 per US dollar.
What are the factors that have led to a stronger US dollar? And what are the effects of a stronger dollar on the US economy, the global economy, and the Egyptian economy?
Let’s start with the basics: the global economy, like any economy, is driven by the market forces of supply and demand. These two forces set the (real) price of all commodities, like petroleum, natural gas, gold, metals, food, and so on. They also set the (real) exchange rate of all currencies, whether global currencies such the US dollar, the euro, the pound sterling, or the Chinese yuan, or local currencies in Third World countries.
These two global market forces, supply and demand, have recently been affected by global events such as the Covid-19 pandemic and the Russia-Ukraine war. The interaction of these two market forces with such major global events, in addition to the status of the US as the world’s strongest and largest economy (or second-largest economy, depending on the economic indicators used) and the status of the US dollar as the world’s strongest currency, shape the current trajectory of the global economy.
The dollar accounts for about 59 per cent of global foreign reserves, and 40 per cent of global cross-border financial transactions are done in US dollars. It also constitutes 90 per cent of all foreign-exchange transactions.
The strength of the dollar is backed by strong global demand and by the strong US economy. The economic performance of the US, like that of any country, is based on its agricultural sector, its industrial sector, its financial sector, and its services sector. If the indicators of these sectors are high, then they will feed into an increase or appreciation in the value of the dollar. This works in the opposite direction as well, as the power of the dollar feeds into US economic performance.
If the dollar is stronger, then this indicates a strong financial sector, which creates confidence in US economic performance and increases investments. On the other hand, a strong dollar means that US exports will be less competitive as they will become more expensive as importers will have to pay more of their currency per dollar.
One reason for the current strength of the dollar is the rising demand for it during the economic uncertainty through which the world is currently going. The dollar usually rises in times of economic crisis or turmoil, as noted in a previous article, because demand for the dollar increases during such times. People and markets “take shelter in the US dollar” because they consider it to be a safe haven, or a haven currency, against economic uncertainties. Again, this feeds back to the rise in demand for the US dollar and therefore to the rise in its value.
A trend of this sort has been taking place this summer. The world is going through the problems of the post-Covid-19 recovery and the Russia-Ukraine war, and the US is suffering from high inflation rates and uncertainties about future economic growth. Therefore, people around the world are demanding dollars, causing its value to rise.
The dollar has thus far gained 10 per cent in 2022 (a 20-year high) against a basket of currencies that includes the euro, the pound sterling, the Japanese yen, the Canadian dollar, the Swiss franc and the Swedish krona. The main competitor of the dollar, the euro, is weak due to the repercussions of the Russia-Ukraine war. The dollar has reached near parity with the euro because of the repercussions of that war.
INTEREST RATES: Another reason for the increasing value of the US dollar is the Federal Reserve’s increases in US interest rates.
In March, the Fed raised interest rates by 0.25 per cent in the US. In May, it raised interest rates again by 0.5 per cent in order to fight inflation. On 15 June, it raised interest rates by 0.75 per cent, the highest increase since 1994. Then it raised them again by 0.75 per cent on 27 July. US interest rates are currently around 2.25 to 2.5 per cent. These rates are a reference point for the rates that the large commercial banks charge for lending to each other.
The reason for the Federal Reserve’s increase in interest rates in the first half of 2022 was to fight the high inflation caused by high demand during the post-Covid recovery and the increased price of oil and commodities caused by the Russian-Ukrainian war. The Fed is responsible for the monetary policy of the US, and it has two main aims: to keep unemployment low and to keep inflation low. Currently, the Fed aims to keep US inflation at about two per cent. It was 8.6 per cent in May.
Higher interest rates increase the costs of borrowing money and therefore slow down spending and reduce the amount of money in the economy. Interest rates in the US reached 20 per cent in 1980 to curb double-digit inflation, and they reached as low as zero per cent in 2008 to encourage investment during the Great Recession and again in 2020 to encourage investment though the Covid crisis. What the Fed is trying to do now is to achieve a “soft landing” by reducing inflation without causing a recession in economic activity. It is “a very delicate balancing act”, according to one financial analyst.
Many central banks around the world have increased their interest rates, but the Fed has increased them more aggressively than most. Currently, the Fed offers higher interest rates than the central banks of most of the world’s large economies, and the winners of this interest rate hike by the Fed include Americans who have savings in banks in US dollars since the interest rates payable on these will increase.
This is why demand for dollar investments such as US treasury bonds has become higher, thus increasing the value of the US dollar even further. That is how speculators in the international markets also contribute to the fluctuating of currencies. They control so-called “hot money” or money that is moved by investors who do not settle it in one place for a long time. Their business model is that they shift their money, or their investments, from one place or one country to another depending on which gives them a higher return or a higher interest rate. They seek short-term, high-return investments, such as forex markets, stock markets, and other short-term instruments.
These investors enter a market as soon as they see a potential for high returns. As soon as the returns decrease, they quickly withdraw their money and seek to shift it somewhere else with higher returns and so on. US treasury bonds and deposits in US banks in US dollars have become more attractive with the Fed’s increases in interest rates.
However, the irony is that the dollar is strengthening at a time when there are fears about US economic performance. In mid-July, the Bank of America forecast that the US economy would face a “mild recession” in the second half of 2022 because of declining consumer spending on services and luxury goods caused by the continuing repercussions of inflation.
Inflation reached a 40-year high in the US in June, as consumer prices increased by 9.1 per cent from June 2021 to June 2022 and by 1.1 per cent from May to June 2022. The main driver for this inflation was the rise in petrol prices, which reached record highs of $5 per gallon in the US in June, in addition to the rise in food and consumer prices.
This “mild recession”, said the Bank of America, would be followed by one per cent growth in the first quarter of 2023. It is indeed ironic that the dollar is increasing in value at the same time as the purchasing power of the American people is decreasing because of inflation. The dollar is increasing in value despite the inflation and getting stronger vis-à-vis other currencies like the euro and the yen.
MIXED BLESSINGS: A strong dollar is a mixed blessing for the US economy. It is a sign of economic confidence that attracts investors. American tourists travelling abroad will receive more of the local currency for their dollars.
But a stronger US dollar may be a cause of concern for US multinational corporations. These operate internationally and sell their products in currencies other than the dollar. They will have to increase the prices of their products in order to get the same price in terms of dollars, which makes them less competitive. Otherwise, they will report less profits abroad. US market analyst Ben Laidler has forecast that the rise in the dollar will reduce the earnings growth of companies listed on the S&P 500 Index this year by five per cent, or roughly $100 billion.
Regarding the global economy, a strong dollar is also a mixed blessing. On the one hand, the US is the engine of global economic growth, so a strong US dollar is a sign of strong US economic performance that may contribute to strong global economic performance. On the other hand, a strong dollar puts additional strain on the budgets of countries that are heavily dependent on oil imports, which are priced in dollars, such as India, South Korea, and Thailand. When oil becomes more expensive, it also leads to higher global inflation, projected to reach 6.7 per cent in 2022, according to the UN Monthly Briefing No 161 in June, and therefore slower global economic growth.
The irony is that whenever people are worried about the global economy, as they are today, the dollar tends to strengthen as it becomes a haven currency and people take shelter in it.
These are the effects of a strong dollar on the US economy and the global economy. Of course, there are currencies that have appreciated against the dollar, such as the Russian rouble, due to capital controls imposed by Moscow. Other currencies that have appreciated against the dollar include the Uruguayan peso and the Brazilian real, since Uruguay and Brazil are major food exporters and the global price of food has increased.
THE DOLLAR IN EGYPT: The history of the US dollar in Egypt is unique. It is a fact of life that the Egyptian pound has never seen any considerable appreciation, or rise, in relation to the US dollar.
Perhaps this is a sign of what some Egyptian economists have called the “Egyptian dollar”, a term coined in Egypt in the late 1980s to indicate that the US dollar has kept rising and rising in Egypt over the years, regardless of the greenback’s fluctuations in the international market.
The dollar/pound exchange rate has traditionally been managed. But there have been four major floatations of the pound over recent decades vis-à-vis the global currencies including the dollar, all of which have led to the devaluation of the pound.
The first major floatation of the pound was in October 1991, the second was in January 2003, the third was in November 2016, and the fourth was in March 2022. These were not totally free floatations, however. Instead, they were managed as the government did not allow the totally free floatation of the pound, fearing that it would gravely depreciate against the dollar, with negative repercussions on the economy.
The events of the spring and summer of 2022 have dealt a powerful blow against the Egyptian pound. On the one hand, there has been the fourth floatation of the pound, which took place in March. There were several reasons for the government’s decision to float the pound then. One reason was that Cairo is currently negotiating a loan with the International Monetary Fund (IMF), and this has demanded a devaluation of the pound.
It is well-known that the IMF puts conditions on a borrowing state, including the reduction of government spending in order to help the government save more money and be able to pay back the loan, plus the interest on the loan of course. The reduction of government spending could include the reduction of subsidies, the reduction of public-sector wages, and the reduction of other costs.
A managed and not totally free floatation of the Egyptian pound means that the government is, metaphorically speaking, bearing the cost of supporting a part of its value vis-à-vis the dollar and other currencies. This cost, borne by the government, is the difference between the free-floating exchange rate and the managed-floating exchange rate. The IMF wants the government to save the cost it is paying, metaphorically speaking, for supporting the value of the pound.
Another reason for the floatation is that it helps to prevent the emergence of a black market for dollars, in which the dollar is sold at a rate higher than the official one and without the regulations put in place by the government. A black market for the dollar thrives when there is high demand for US dollars, and the banks are unable to satisfy this demand. This leads people who need dollars to resort to the black market, even if they have to pay more for them.
The floatation and devaluation of the pound helps to weaken the black market since the dollar becomes more expensive and therefore reduces the profits of sellers in the black market. But the floatation of the pound alone is obviously not enough to prevent the emergence of a black market, as it has to be supplemented by government inspections and legal procedures to combat its emergence.
Other factors that have dealt a blow against the Egyptian pound have been international events. One of them was the Federal Reserve’s increases in interest rates in 2022. Since the Fed’s interest-rate hikes make savings in US dollars more attractive, emerging markets reacted to this hike by increasing savings in US dollars, thus causing an increase in the value of the dollar and, in turn, a devaluation of their national currencies. This happened to the Egyptian pound.
In addition, when the Fed raises interest rates, hot money speculators shift their dollar, or hard currency, investments from Egypt to US treasury bonds in search of higher returns.
Global inflation, too, has had a negative effect on the value of the pound. Inflation in Egypt is caused by the Russia-Ukraine war, in addition to the recent 17 per cent devaluation of the Egyptian pound vis-à-vis the dollar. The Central Bank of Egypt (CBE) has raised interest rates in order to fight inflation.
Obvious losers from the devaluation of the pound include people who receive their incomes in Egyptian pounds. They also include Egyptian consumers, as the purchasing power of the pound has declined, as have the assets of those who have deposits in Egyptian pounds. Other losers include Egyptian importers, as they now have to pay more Egyptian pounds per dollar (or other foreign currency) to import foreign commodities, making the latter more expensive, and therefore less attractive, to the Egyptian consumer.
On the other hand, there are also those who benefit from the devaluation of the pound. They include people with deposits in foreign currencies, people who work abroad and/or receive their salaries in foreign currencies, and foreign tourists in Egypt who will get more Egyptian pounds for their currency. Another winner is Egyptian exporters, as Egyptian exported commodities will now cost foreign importers less in terms of Egyptian pounds, making them more competitive.
There is an opportunity in the devaluation of the Egyptian pound vis-à-vis the dollar and other hard currencies. This opportunity for the Egyptian economy exists in two important economic sectors: the export sector and the tourism sector.
In terms of exports, the devaluation of the Egyptian pound makes exported Egyptian commodities cheaper since foreign importers will now pay less in dollars for the same commodities as they did before the devaluation. This will make Egyptian commodities more competitive vis-à-vis similar commodities from other countries.
In terms of tourism, Egypt will become a cheaper and more attractive tourist destination, since foreign tourists will get more Egyptian pounds for their dollars or other foreign currency. The authorities should pay more attention to these two important sectors and to the supporting industries around them like manufacturing and packaging in order to maintain an advantage in the production of certain Egyptian commodities or the provision of certain services.
The writer is a political science lecturer at the British University in Egypt, a member of the Egyptian Council for Foreign Affairs and the Royal Institute of International Affairs, Chatham House, UK.
*A version of this article appears in print in the 4 August, 2022 edition of Al-Ahram Weekly.