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Comment by Zoran Panović

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David Mališ, Head Of The National Bank Of Serbia’s Reserves Management Division

Our Currency, Your Problem

At a juncture when the attention of everyone is directed towards the moves of the monetary authorities of the U.S. and EU, we are perhaps missing out on focusing on another question: do current developments herald the future rise of Asia and the creation of some new safe havens, at least economywise?

There’s no topic that’s being debated around the world of international finance more than that of the future of the dollar as the world’s reserve currency, and there’s no less debatable fact than that everyone wishes they had that same dollar whenever a crisis hits. And the current and previous year were no exceptions when it comes to confirmation of this fact. The dollar appreciated more than it has in the last 40 years, even outdoing the strengthening it experienced during the period of the COVID pandemic, when a shortage of dollars on the global market led to the so-called “liquidity squeeze”. Over the long term, the real exchange rate of the dollar appreciated by over 40% in the 2011-2022 period, marking the second largest increase in the post-Bretton Woods era. At the end of September 2022, the EUR/USD exchange rate had fallen to below 0.96, the lowest rate of the last 20 years.

The key cause of the dollar’s strengthening against the euro can be attributed to the rise in yields in the U.S., which came as a result of the accelerated policy tightening of the Federal Reserve. The war in Ukraine, and the subsequent problems of European economies, additionally contributed to the U.S. dollar’s safe haven status. But why is this strengthening of the dollar, as a result of the aforementioned reasons, even important? Rising interest rates in the U.S. make borrowing more expensive, and has a negative impact on risky assets, particularly in less developed countries. In contrast to the previous period when interest rates hit an unprecedented low, in a situation of rising inflation, currency depreciation only contributes to inflation through the “pass through” effect. The appreciation of the dollar has a negative impact on all those who borrow in dollars, whether they are companies or states, because that makes debt repayment more difficult from the perspective of the local currency. All this prompted states to intervene with the aim of defending their currencies, either through FX interventions or with interest rate hikes, in order to maintain the attractiveness of the domestic currency by preserving the interest rate differential. But high interest rates don’t come without a cost – as they place a burden on the local economy.

Reversing the dollar’s bull trend trend requires the simultaneous meeting of certain conditions. The first is for the U.S. FED to abandon the policy with to abandon the policy of unconditionally taking down inflation. The second is for the global economic environment to be sufficiently attractive to “lure” portfolio flows away from the dollar. As such, a question remains as to whether the conditions among the trade partners of the U.S. will be attractive enough to “drive away” these flows? If we were to limit ourselves to the EUR/USD, as the most traded currency pair, what could be expected in the coming year? The key questions are: 1) how far will the FED go in policy tightening and how will it be followed by the ECB? 2) how will European economy fare and how will it be impacted by the Ukraine war and related energy crisis? 3) will the opening and recovery of chinese economy occur? 4) what will the global perception of risk be like?

The key cause of the dollar’s strengthening against the euro can be attributed to the rise in yields in the U.S., which came as a result of the accelerated restrictive policy of the Federal Reserve

There is a slight possibility that the ECB will be the first to implement a monetary policy pivot. The German economy could enter a recession and the ECB might halt its cycle of rate hikes even before the 3% priced by the markets. If the FED’s terminal rate is around 5% and it remains remains at that level for the foreseeable future, if the Germany enters recession for several quarters is realised, if Chinese economy slows down, and in the case that global risk perception remains high, there won’t be too many arguments for a more pronounced recovery of the euro. Energy could represent another significant factor: problems problems in energy supply at affordable prices could limit the recovery of the euro. More broadly, weak global demand doesn’t suit procyclical currencies like the euro.

In selecting between different scenarios, Société Générale Bank favours the more positive choice: financial markets are beginning to slowly accept the idea of a relatively moderate slowdown as opposed to a deep recession, which implies limited rise in yields and less fear of geopolitical risks. All of this could impact on weakening the dollar, though that doesn’t change the situation much when it comes to the euro, at least until a lasting and affordable solution can be found to to energy supply shortages in Europe. The one thing that is certain is that there will be no there will be less clear FX trends throughout 2023 and volatility will remain elevated.

According to experience, emerging markets (EM) tend to suffer the greatest hits during the crisis. However, SocGen expects EM to be resilient to shocks during the coming year, with growth being bolstered by the normalisation of economic activity and by recovery of supply chains, by limiting of negative impacts of the war in Ukraine and China’s economic recovery. Strong dollar hurt real economy of EM in the past, as well, but it seems it isn’t the case now, at least not in general terms, but it seems that this isn’t the case now, at least not in general terms. In real terms, the projected average growth of EM GDP in 2023 stands at three per cent (Credit Suisse projections).

However, the picture changes when you delve into the details: differences are obvious at the regional level. While Latin America is expected to experience economic deceleration due to weaker domestic demand, Asia is expected to grow, sparked mainly by the recovery of the Chinese economy. In a broader context, Asia, which has learned from the experiences of the crisis of the 1990s, now has considerable foreign currency reserves with deeper and more liquid domestic financial markets deeper and more liquid domestic financial market. All this serves not only to make it the fastest growing part of the world, but also – paradoxically – a bastion of stability. The countries of Eastern Europe and the Middle East (CEEMEA) remain juxt a posed to that, and that picture and that picture changes a lot with Nomura’s early warning indicator of exchange rate crises, suggestively named Damocles. Such early warning signs can be seen for Romania, Czechia, Hungary, Turkey and Egypt. And the indicators are discouraging: of the 32 countries monitored, results have worsened in 22, while they have only improved in three. Making matters worse, the overall score is the worst since 1999 and isn’t far from the peak at the height of the aforementioned Asian crisis. This indicator successfully predicted 64% of the previous 61 currency crises.

Despite all these findings being logical at first glance, given that the conflict is primarily contained within European frameworks, and that risks are deepened by the actions of the countries of Europe, there is perhaps deeper meaning to be found in this decoupling of EM countries? What if this is also confirmation that the future is shifting towards Asia? And that it is perhaps there that we should seek some future safe havens?

The views expressed in this article are personal and do not represent official positions of the National Bank of Serbia