In an unprecedented move, Britain voted to leave the European Union on 23 June. The ramifications of this historical vote are being felt across the globe, not least in the financial markets. In the immediate aftermath of Brexit, as investors sought safe havens amid volatile markets, the US dollar posted its biggest two-day gain against the pound since November 2011.
This article considers some of the factors that have led to and support the continued strengthening of the US dollar and the likely consequences for African economies.
What factors have led to a strong dollar?
Ralph Waldo Emerson said, "the value of a dollar is social, as it is created by society." Emerson's view was that the dollar holds no inherent value in its own right, rather the value stems from the principles our society holds. If this is true, being able to decipher the factors that caused an increase in the value of the dollar should help us understand some of the most valued principles in our society.
It is no great surprise to find that stability is a factor valued by society and has, therefore, played a large role in determining the price of the dollar. Most economists would agree that in turbulent times investors turn to countries that show structural and governmental stability. The future shape of the European Union is now a complete unknown and so investors might understandably be more wary of making any significant investments in Europe for the foreseeable future. Similarly, the slow pace of structural reform in areas such as tax and employment in many African nations will influence investor sentiment towards the African continent. These and other perceived uncertainties seem to have encouraged investors to look to the comparatively stable US economy and hold more dollar-based investments, thereby facilitating the rise in its price.
The rate of interest in a country or economy also plays a role in the value of its domestic currency. There are many theories explaining the rationale behind interest rates. The "abstinence theory", for example, which states that the investor has to be compensated for abstinence or for not immediately using his own capital. Put simply, we generally expect to receive interest on our capital investment. A higher interest rate means a better return on government securities such as bonds and gilts and this will, all else being equal, attract more foreign investment. In the current climate, there has been a decline in yields on European bonds. On the other side of the Atlantic, there has been speculation for some time that the Federal Reserve will hike the US domestic rates towards the end of this year. With such an increase, the dollar is likely to strengthen further against other currencies as investors seek greater returns on secure, US government assets.
Currency speculation also has an impact on the value of a currency. Post-Brexit volatility has created opportunities for currency traders to make short-term gains by trading the pound and other currencies according to how they think the market will move. Although this may be an inaccurate reflection of their views on the British economy in general, traders have shunned Britain's currency and instead turned to currencies, such as the dollar, where they see more certainty in the short-term. As the demand for the dollar increases, it becomes stronger against other currencies.
A strong currency often has a negative effect on a country's exports because it makes them more expensive. For now, US exports still remain in high demand and the US economy is not overly reliant on its exports, given its huge domestic demand. Nevertheless, it is a delicate balancing act and, if left unaddressed, could lead to the eventual weakening of the dollar.
What does this mean for African economies?
African countries hold significant dollar denominated debt. In the 1970s, against the backdrop of the booming oil prices and negative interest rates, African economies were able to service their dollar debt. Today, the oil price and the price of other commodities are low while the dollar is strong, and strengthening. As a result, African governments and corporates will find it harder to service dollar denominated debts, especially where they earn revenues in local currency. Whilst African governments and corporates might increase output to keep up with the strengthening of the dollar against the relevant local currency, this is almost impossible, particularly if the production of their commodity depends on importing machinery or other input goods from abroad.
Although neither direct nor immediate, an increase in the US federal funds rate has an impact on other benchmark rates like LIBOR, making Eurodollar loans more expensive. African government debt might seem far less attractive when US government bonds offer higher yields, in addition to being a practically risk-free, stable investment.
Some may argue that the stronger dollar should be viewed as an opportunity for Africa as it results in inward investment into Africa being cheaper for US investors, and in dollar-based African exports being comparatively more competitive. However, the rush to emerging markets will not materialise if foreign investors remain nervous about continued local currency depreciation, and its impact on local currency returns once converted back into dollars. Similarly, investors will continue to be concerned about political instability, weak local manufacturing capability, a lack of structural reform (including tax and labour reforms) and a lack of economic diversification. Without any strong evidence of policies which seek to tackle these issues, investors will remain cautious of long-term commitments in Africa, regardless of their relative affordability.
Once the dust settles over Brexit and we see the global economy recalibrate, Africa will be affected by the value of the dollar. But its destiny will ultimately be written by its leaders and how well they manage to navigate an increasingly globalised world where investors, like society generally, attach great value to stability and good government.
As published in Without Prejudice in September 2016.