6 minute read
Have you heard of the term “dollar shortage” or the "dollar gap"?
It refers to a scenario where foreign countries lack U.S. dollars in their reserves to conduct international trade effectively.
Simply put, a dollar shortage occurs when a country's USD outflows exceed its inflows. This can happen if it pays more dollars for imports than it earns from exports or has higher international dollar obligations (such as dollar debts).
And this is a big deal because the U.S. dollar is the global reserve currency – meaning the dollar’s status is a stable currency making it widely used for pricing assets - and all countries and companies will accept dollars. After all, they know they can use those dollars to buy from anyone else.
Why the Dollar Shortage Matters
The U.S. dollar accounts for over 70% of global reserves, dwarfing other currencies like the Euro, Pound Sterling, and Yen.
This is a key reason why the U.S. always runs a deficit – because it must net-export dollars.
Or said another way, if the U.S. doesn’t buy more than it sells abroad, how would anyone get the dollars they need?
I wrote about this in depth back in December 2023 – “The U.S. Dollar: An Exorbitant Privilege? More Like An Exorbitant Burden – Here’s Why“ – to touch on this paradox.
But the key point here is that the global economy constantly needs dollars (the reserve currency). Thus the U.S. obliges by running huge trade deficits (aka exporting dollars), giving the world the dollars they need so that they import from each other, and international trade keeps humming along.
Simple, right?
Well, this is where things get tricky. . .
Many institutions around the world have significant dollar-denominated debts.
Meaning a company or country issues “dollar bonds” – aka borrows in US dollars rather than their domestic currency (for example, Mexico may issue bonds denominated in U.S. dollars instead of the Peso because it’s more attractive to investors and less volatile).
Why is this a problem? Because the borrowing country – let’s keep using Mexico as an example here – must constantly get dollars to repay the dollar debts. And if they can’t export enough to bring in dollars, they have a higher risk of defaulting on their dollar loans.
- Remember, these countries can’t create dollars like the U.S. Treasury can (they don’t have the proverbial dollar printing press plates).
And this is becoming a huge problem with so many nations loaded up with U.S. dollar debt. . .
The Rising Crisis of Dollar Debt
According to the International Monetary Fund1, there are roughly 70 countries (most frontier or emerging economies) at risk of debt distress - meaning they might default on their foreign loans. That’s more than a third of all countries in the entire world.
The numbers are staggering:
- In 2021, developing nations paid $400 billion in debt servicing—double the amount they received in development aid.
- Their international reserves fell by $600 billion that same year.
In fact, this debt issue has become so severe that the secretary-general of the United Nations Conference on Trade and Development - Rebeca Grynspan – called it one of “the biggest threats to global peace and security2.”
And this is why it’s called the global dollar shortage.
Because many countries and corporations all around the world lack enough dollars to continue servicing their debts.
But here’s why it may get worse. . .
How U.S. Federal Reserve Policies Worsen the Shortage
Since the Federal Reserve began raising interest rates, the dollar has continued getting stronger relative to foreign currencies.
- Remember, currencies are relative. Thus, for Currency A to rise, Currency B must see a decline (assuming only two currencies for simplicity).
But this trend really started back in 2014 when the Federal Reserve began tapering back its aggressive easing post-2008 and started talking about raising rates.
To put this into perspective, since summer 2014, the U.S. dollar index (the DXY) is up 25%.
So why does this matter?
Because when the dollar gets stronger, it means the cost of those getting those dollars increases for foreign countries.
In fact, evidence shows that when a country’s currency weakens against the dollar, the cost of imports from the United States rises, putting upward pressure on prices. For instance, on average, a 10% dollar appreciation translates into a 1% increase in inflation abroad3.
Why? Well, since commodities - like oil, wheat, and metals - are priced in dollars, then a stronger dollar raises the costs of these goods.
Making matters worse, because food and energy expenditures constitute a larger share of consumption in emerging economies, increases in dollar-priced commodities significantly raise their cost of living.
Put simply, higher rates lead to:
- Increased import costs for nations with weaker currencies.
- Rising inflation, particularly in economies heavily reliant on dollar-priced commodities like oil and wheat.
- Capital outflows, as investors pull money from riskier markets in favor of U.S. assets.
But this is particularly problematic for governments and companies in emerging economies, as most of their borrowing is in dollars (as I mentioned above).
A Worsening Problem for Emerging Economies
Here’s a quick history lesson: after the 2008 Global Financial Crisis, these emerging economies saw strong capital inflows after above-average growth and interest rates attracted investors (and money). Thus, as a result, borrowing in emerging economies grew, with over 80% of this debt denominated4 in foreign currency - primarily U.S. dollars.
So, countries or corporations that borrowed in U.S. dollars are now stuck dealing with an increased cost of getting those very dollars they need to pay back the debt.
Lovely, right?
Making matters worse, the pandemic caused a sharp reversal in capital flows as U.S. interest rates rose, leading to credit rating downgrades in many emerging economies.
Thus, those with high levels of external debt relative to foreign exchange (dollar) reserves experienced large-scale capital outflows and dramatic currency depreciations – amplifying the dollar shortage.
Wrapping It Up
The global dollar shortage – where foreign nations are struggling to get dollars to repay their liabilities and imports – seems to be getting worse.
Remember, an ever-growing amount of dollar-debt globally means an ever more amount of dollars needed to service it.
Thus, while many in the mainstream financial media talk about the dollar-debt problem, I believe it’s more important to discuss the servicing ability of that debt – aka the global dollar shortage.
The strong dollar is acting like a wrecking ball for emerging economies – crushing borrowing capacity, credit ratings, currencies, capital flows, and imports.
And all this doesn’t even account for the roughly $65 trillion (yes, trillion) in “hidden” dollar debts5 that’s mostly held outside the U.S. (I will go into this in more detail in an upcoming Morning Pour).
Things will likely keep getting worse for the global economy if this trend persists – which I believe it will.
Of course, if the Fed cuts interest rates, that may take some pressure off emerging markets and their currencies.
But the big question is: can many last until then?
As always, this is just some food for thought.
Sources:
- List of LIC DSAs for PRGT-Eligible Countries, As of April 30, 2024 (imf.org)
- The world lacks an effective global system to deal with debt | UNCTAD
- Global Repercussions of the Strong Dollar | Econofact
- US Dollar Funding and Emerging Market Economy Vulnerabilities - Financial Stability Board (fsb.org)
- Dollar debt in FX swaps and forwards: huge, missing and growing (bis.org)
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