The U.S. dollar continues to be one of the world's major currencies and its influence can be seen in markets and economies far distant from its shores. The effect the US dollar has on other currencies, in particular those of emerging markets, is therefore worth considering in more detail.
In the eyes of most investors the US dollar has rallied significantly since the beginning of last year. The euro-US dollar rate has moved down, while the US dollar has strengthened significantly against the Japanese yen.
There is no doubt that the US dollar has rallied against some of the big currencies and that is clearly evident when one looks at the Federal Reserve Bank's trade weighted index for the major trading partners or the Bank of England's trade-weighted index.
However, although the US dollar has risen against the major currencies, which accounts for over half of its trade-weighted value, it has moved in roughly an equal and opposite direction against emerging currencies.
Since January 2005 the US dollar has fallen over 3% against emerging market currencies. So putting the other currencies and the major currencies together in the correct weights, we find that since the US dollar rally started in January last year it has risen less than 1.5%.
Based on this evidence, one can conclude that the US dollar is rallying against the major currencies but falling against those of emerging markets, and is thus relatively flat in aggregate trade-weighted terms.
The one question that needs to be asked is how will these emerging markets react if the US dollar were to suffer a draw-down? In such a scenario, it is highly likely that other major currencies will rally against the US dollar. However, whether those of emerging markets will continue to do the same, remains to be seen.
To date, excess liquidity and capital flows have also helped the rise in emerging market currencies against the US dollar. However, there are some important implications to consider. Primarily, whether we are in a new regime of higher capital flows relative to trade and if not, when capital flows drop back, by how much will emerging currencies fall.
More importantly, when the US dollar falls, it needs to fall across the board so as to rectify the trade imbalance. Otherwise, the result will just be the opposite of today, where the US dollar will rise against the 'majors' and fall against the emerging currencies. Such a situation will not rectify the imbalances.
Assuming the world starts to worry again about global imbalances, there is no doubt the US dollar rally against the dominant currencies will reverse. In other words, the euro and the Japanese yen will rise. Global cross-border flows will slow.
However, there is no guarantee that emerging markets will come down with it. Previously, emerging markets would experience a downturn by a lot more than the liquidity measure would suggest. As excess liquidity dried up, emerging market currencies fell and concerns about their current account deficits and external US dollar debt accelerated the move.
In the view of HSBC Research there are various reasons for emerging market currencies' rise against the US dollar, even in an environment of falling liquidity. First and foremost, emerging markets, as a group, are less reliant on global liquidity than they have been in the past and will therefore weaken less than they have done historically as a response to tighter liquidity conditions.
Reliance on global liquidity has fallen because emerging markets are issuing less debt than they have done in the past. Of this debt, an increasing proportion is denominated in local currency as opposed to foreign currency and foreign currency debt issuance has diversified away from US dollars.
Falling emerging market debt issuance is a consequence of generally improving economic fundamentals across the emerging market world, in part because of the corrective impact of a past bout of tighter liquidity and rising risk aversion.
Emerging markets have learned to become less reliant on foreign capital by narrowing fiscal deficits and trimming dangerous external account imbalances, which are only sustained through capital inflows.
Another reason to believe that emerging market currencies are less vulnerable to tighter global liquidity is that emerging market investors are more discerning and reliable than in the past. There are many more dedicated emerging market funds that reflect long-term investor commitment based on more reliable information.
It is precisely because tightening liquidity conditions have had such an negative impact on emerging market currencies and debt service capacity in the past that emerging countries have sought to insulate themselves from similar circumstances in the future.
This time it really is different for emerging markets, as they have little external debt in US dollars, current account surpluses and the pressure on exchange rate pegs is for revaluations not devaluations.
Therefore, if liquidity does dry up as the US dollar falls, emerging market currencies will either rise or fall a lot less than the change in liquidity would dictate. This would be the opposite of the Asian crisis situation.
However, to attain the necessary adjustment to the global imbalances the US dollar will need to fall against all currencies.
This report was compiled by Peter Calleya, manager Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.