Market players do not believe the Bank of Mexico can separate its monetary policy from that of the US Federal Reserve, Bank of Mexico Deputy governor Galia Borja Gomez said in an interview published in late August.
The Fed in recent months has been tightening monetary policy in an effort to slow the rise in prices. The Mexican central bank, also known as Banxico, faces pressure to follow suit or risk its currency depreciating against the dollar, exacerbating inflation at home.
The dollar’s nominal effective exchange rate against a broad basket of currencies, including from both advanced and emerging economies, is now at one of its highest points since it started publicizing the data in 1994, according to the Bank for International Settlements.
Going back further, a comparison against currencies from advanced economies alone finds the greenback approaching its highest point since 1985 – shortly before major economies signed the Plaza Accord to correct an exceedingly strong dollar.
Amid concerns of an economic slowdown, investors are pouring more funds into the US to take advantage of higher interest rates there. The yen on Thursday weakened to 140 to the dollar – a threshold not crossed since 1998.
The strengthening dollar could have wide-ranging effects on the global economy, especially in countries that face mounting dollar-denominated debt. Public and private-sector debt in developing countries had grown roughly 10% over a year to US$98.6 trillion as of the end of March, according to the Institute of International Finance.
Debt in emerging and developing countries equalled 207% of their gross domestic product in 2020, according to the World Bank – a dramatic increase from 56% in 1970 and 119% in 2010.
The coronavirus has only exacerbated this trend. After central banks across the world eased monetary policy to spur economic activity amid the pandemic, investors flocked to emerging countries in search of higher yields. A quarter of government debt in key emerging countries was denominated in foreign currencies in 2020, up from 15% in 2009.
Historically, a strong dollar has spelled trouble for emerging economies. When the US faced soaring inflation back in the 1980s, then-Fed chairman Paul Volcker responded with an aggressive tightening campaign that sent interest rates and the dollar soaring.
Meanwhile, more money was flowing across the world in the wake of the Nixon Shock of 1971, when then-president Richard Nixon took the dollar off the gold standard. Oil-rich nations were dumping the cash they had earned during the oil price shock into major US banks, which in turn funded an investment rush in Central and South America in the form of syndicated loans.
More than half the foreign debt held by Central and South American nations at the time was believed to have been denominated in dollars. Many struggled to make repayments as the dollar strengthened and American interest rates rose, even as their economies weakened and commodity prices fell.
Major US rate hikes in the mid-1990s under then-Fed chairman Alan Greenspan paved the way for a currency crisis in Mexico. The Asian financial crisis followed after investors began selling the Thai baht and other dollar-pegged currencies they saw as overpriced.
Many emerging economies have since been working to improve their balance of payments and bolster foreign reserves to better defend themselves against a crisis. Some emerging nations that raised interest rates ahead of the US are seeing their currencies remain firm.
Still, some countries have begun to falter. Sri Lanka defaulted on its foreign debt earlier this year, while Bangladesh and Pakistan are seeking support from the International Monetary Fund.
Continued inflation paired with a strong dollar could push more countries into default.
Given “high debt and sizable fiscal and current account deficits” in emerging and developing economies, “there is a danger that financial stresses will emerge in these economies and further hold back their recoveries from the pandemic,” the World Bank warned in a June report.