Ask a typical banker or investor about the role of finance in the economy. The standard justification for its existence is that it provides credit to the productive sectors of the economy. But as job losses in the United States mount, and the world economy expected to slow down to levels unseen since the Great Depression, why has the U.S. stock market ceased to reflect the lack of economic activities?
One trend that partially explains this discrepancy has been steady and certain during the Covid-19 crisis: the one-way movement of financial assets from emerging markets into the U.S. dollar.
Keen to minimize the risks of virus-related volatility, international investors have pulled US$59 billion out of a group of major emerging market economies in the one month prior to March 24, more than double the amount withdrawn in the 2008 global financial crisis.
Much of this money is bound for the safety of U.S. dollar-denominated assets. The result has been a steep decline of emerging market currencies against the dollar, with the Mexican peso, Russian ruble, Brazilian real, and South African rand all declining by 20 percent or more in the first quarter of 2020.
The widespread perception of the unparalleled stability of the U.S. financial system underlies this one-way financial flow into the U.S. dollar. As Adam Tooze argued in the London Review of Books, both the 2008 financial crisis and the economic shock of the coronavirus have given credence to worries about China and the Eurozone. This, along with the role the U.S. dollar plays in underpinning global trade, has contributed to the notion that in times of generalized uncertainty the U.S. dollar is the ultimate safe-haven asset.
Investors eschewing emerging market assets for the singularity of the U.S. dollar certainly go against investors’ usual calculations to minimize risks and maximize returns. In normal times, investors, unable to fully predict the future course of economic development, find it wise to distribute their funds among different economies, reducing the possibilities of their asset values swinging to the fortunes of any particular national economy.
Investing only in one type of asset not only reduces economic diversity. It also isn’t economically efficient. The concentration of global wealth in the dollar forgoes the much higher returns on investment that are available to investors in emerging markets. Parking money in U.S. dollars represents an opportunity cost for funds to be used more productively for higher returns.
Yet, even that comparatively low interest rate of the U.S. was a factor cementing U.S. dollar dominance in the past years. Tooze noted that coronavirus did not trigger but simply accelerated the movement of money into the U.S. from 2013, as the low borrowing costs and high stock market returns in the U.S. prove too alluring for investors seeking good returns. In comparison, high interest rates in emerging markets were accompanied by high inflation and low economic growth, making the U.S. one of the G20 economies with the highest real return on investment even before the coronavirus emerged.
As capital continues to flee emerging markets to dollar assets, it is emerging markets, rather than cautious investors, that will suffer greater permanent economic damage. Just as commodity exports and remittances, two major foreign income earners in emerging markets, decline during the coronavirus pandemic, emerging market governments find themselves unable to plug financing gap at home due to soaring borrowing costs. As dollars exit the economy, some African states are seeing the borrowing rate surge past 20%, making it difficult for local governments to invest in healthcare and fiscal stimulus to cushion the damage from Covid-19.
With Covid-19 wreaking havoc on the global economy, the singular dominance of the U.S. dollar has been reaffirmed, portending devastating effects on emerging market economies. As capital flees into dollar-denominated risk assets, emerging markets find themselves with reduced ability to borrow from abroad, even as their usual streams of foreign incomes dry up. As a result, the dominance of the dollar threatens to exacerbate the already severe inequality between the U.S. and emerging markets, with the U.S. financial system further stabilized by inflows at the expense of emerging markets.
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TNL Editor: Nicholas Haggerty (@thenewslensintl)
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