The dollar is strengthening as Africa is already being hit hard by rising inflation caused by the war in Ukraine. As the power of the dollar increases, inflationary pressures are amplified across the continent, he writes Jonathan Munemo.
The US dollar has been advancing rapidly in response to the Federal Reserve’s determination to keep raising policy rates for longer to regain control of stubbornly high inflation. This has far-reaching consequences. The US dollar is used prominently around the world as a medium of international exchange and as a global reserve currency.
The dollar is strengthening as Africa is already being hit hard by rising inflation caused by the war in Ukraine. As the power of the dollar increases, inflationary pressures are amplified across the continent. That makes it even more difficult for central banks to rein in high inflation. Additional pain will be felt as dollar strength spreads across Africa, causing contracting trade volumes, tighter trade financing conditions, and rising sovereign debt coupled with rising debt service costs.
Another concern is the risk of what has been called the vicious cycle of the dollar. As the dollar strengthens, it becomes a drag on global economic activity, putting pressure on other currencies to weaken and further fueling dollar strength. This outcome weighs further on economic activity, reinforcing currency weakness, setting in motion a self-reinforcing feedback loop of doom. One negative result triggers another.
Concerns have already been raised about a vicious cycle of the dollar for the world economy.
Unfortunately, African countries have few options to respond to the strength of the dollar. And most are challenging.
They could continue to raise interest rates to avoid currency depreciation pressures from the strong dollar. But in doing so, policymakers face a difficult balancing act, as rate increases must be carefully calibrated to avoid triggering an economic downturn.
An alternative option is to try to contain currency depreciation pressures by intervening in the foreign exchange market using foreign exchange reserves. That is also challenging. Many African countries have seen their surplus reserves depleted after large public spending support programs spurred by the pandemic and higher payments for their imports of basic goods.
The value of the US dollar has risen substantially since March 2022, when the Fed launched its aggressive rate-hike campaign in an attempt to tackle stubbornly high inflation. The Federal Reserve’s dollar index, which measures the strength of the dollar against the currencies of a broad group of other major currencies, has risen sharply.
The index has appreciated about 10% since March as Fed officials are laser-focused on fighting inflation.
This has weakened African currencies. The scope varies by country. For example, the Ghana cedi, the Egyptian pound and the Zimbabwe dollar have all tumbled sharply and are now among the top ten worst performing currencies of 2022.
Other currencies, such as the Kenyan shilling and the South African rand, have also tumbled under pressure from a strong dollar.
The dollar’s strength comes as Africa is being hit hard by rising global food and energy prices spurred by Russia’s war in Ukraine. Central banks across the region have been adjusting interest rates to cope with rising inflation caused by the war.
The dollar’s advance is intensifying inflation problems by weakening the currencies of African countries and thus pushing up the prices of dollar-denominated imports. As the value of the dollar rises, it amplifies inflationary pressures. In turn, that makes it even more difficult for central banks to rein in high inflation.
Although a strong dollar improves the competitiveness of African exports, the gains from weaker currencies may not be substantial. That’s because exports are often billed in US dollars. So while a weaker currency makes goods cheaper in domestic currency terms, this doesn’t always translate into cheaper goods for foreign buyers paying in US dollars.
Billing in US dollars is also a prominent feature of trade finance in developing countries. Merchandise trading companies rely heavily on bank financing for working capital, due to the time difference between incurring costs and receiving payments.
A stronger dollar tightens trade finance conditions, restricting businesses’ access to finance. This offsets any improvement in export competitiveness, which further slows down foreign trade.
The African Development Bank has carried out in-depth studies on trade finance in Africa. The International Finance Corporation and the World Trade Organization also conducted a joint study focusing on Côte d’Ivoire, Ghana, Nigeria and Senegal.
These studies find that banks identify the lack of sufficient liquidity in dollars and euros as a major constraint to finance trade. By tightening trade financing conditions, a strong dollar further aggravates working capital constraints for businesses.
The rapid rise in US interest rates is one of the main drivers behind the acceleration of dollar strength. This has considerably tightened financial conditions for African governments with high levels of dollar-denominated debt.
Higher interest rates increase the burden of debt servicing and have raised concerns about debt sustainability, especially for the more than 20 African countries that the IMF and World Bank consider to be at high risk of debt distress or who are already in a situation of over-indebtedness.
African loans to big creditors like China are already facing mounting repayment pressure. Most of these loans are on commercial terms and are denominated in US dollars.
How should African countries respond to the strength of the dollar?
The options are few and challenging. In the short term, there are two main options for African countries. Unfortunately, it’s not a silver bullet either.
The first is to keep raising interest rates to avoid currency depreciation pressures from the strong dollar. However, if official rates continue to rise, they will reduce output and could trigger a recession in some African economies.
Raising rates must be done carefully to avoid an economic downturn.
The second option is to stop currency depreciation pressures by intervening in the foreign exchange market.
This requires the use of foreign exchange reserves to back the currency. This option is not widely available. Many African countries have exhausted their surplus reserves after large public spending programs during the COVID pandemic and higher payments for their imports of basic goods. As a result, foreign currency reserves are already dangerously low in several countries.
According to the International Monetary Fund, one quarter of sub-Saharan African countries have reserves of less than three months of imports and more than three quarters have reserves of less than five months.
As weaker currencies increase the purchasing power of travelers from abroad, one option would be to boost tourism to help prop up local currencies in the medium term.
jonathan munemoProfessor of economics, Salisbury University. This article is republished from The conversation under a Creative Commons license. Read the Original article. News24 encourages freedom of expression and the expression of diverse points of view. Therefore, the opinions of the columnists published in News24 are their own and do not necessarily represent the views of News24.