Fed rate hike and worsening geopolitics are making investors seek safe-haven dollar-denominated assets to strengthen regional currency cooperation

The US dollar has been gaining strength relative to other major global currencies since the beginning of this year. So far, the US dollar index has grown more than 13 percent to hover around 109.The higher-than-expected interest rate hikes by the United States Federal Reserve is the major driver behind the strong dollar. To rein in the runaway inflation, the Fed has increased the benchmark interest rates four times since March, raising the rates radically by 225 basis points altogether. The growing gaps between the interest rates of the United States and other countries have triggered massive capital flows from the rest of the world to the US.

The Ukraine crisis is another key factor behind the surging dollar. The worsening geopolitical instability has prompted international investors to seek shelter and boosted the demand for safe-haven assets. Global capital has been fleeing Europe and emerging economies and flocking to dollar-denominated assets. The turbulent global financial market aggravated by the US interest rate hikes and the Ukraine crisis has pushed the dollar to its highest level in 20 years.

The strong dollar has exerted wide-ranging impacts on the global economy, which risks derailing the economic recovery of developing countries. Since 2021, developing countries in Asia have embarked on paths of recovery thanks to the rebound in external demand. As some countries have been actively approving new investment projects and some have rolled out development strategies to support infrastructure building, investment and consumption in developing Asia have also revived. However, as most Asian developing economies are export-oriented and heavily dependent on external demand, a strong dollar may have significant influences on these countries.

First, a strong US dollar could put pressure on those economies' international trade. It can drive up import prices, leading to heavier cost burdens on enterprises that rely on imports. Moreover, higher import costs may spell imported inflation, dampening domestic demand. In terms of exports, a strong dollar may give developing countries price advantages in exports, countering the negative effects it brings about. However, as the strong dollar is largely the outcome of the US' tightened monetary policy, it will inevitably be accompanied by weak US market demand, which in turn will have a negative influence on the exports of developing countries.

Second, a strong dollar may disrupt the economic growth of developing countries through capital flows and financial markets. The global capital flows to dollar-denominated assets place huge pressures on the stock, bond and foreign exchange markets of developing countries.

In the first quarter of this year, foreign investors withdrew $31.9 billion from China's bond market and $6.8 billion from its stock market, the largest capital outflow on record. In India, about $28 billion has been pulled out from the country's stock market in the first half of the year, the largest among Asia's emerging economies. By mid-June, the Bombay Stock Exchange Sensitive Index－or BSE Sensex－had lost more than 15 percent compared with last October.

However, emerging economies in Asia remain a favorite destination for global investors. Since mid-August, China's stock market has seen a net inflow of capital, and the BSE Sensex has gained its lost ground and rebounded to the level at the end of last year.

Third, a strong dollar puts bigger pressures on the sovereign debts of emerging economies, which, however, is not regarded as a major risk in Asian countries where residents have high saving rates and thus rely less on external debts compared with Latin American countries. In a report released by the ASEAN+3 Macroeconomic and Research Office in April, the realization of a sovereign debt crisis in ASEAN+3 economies (ASEAN countries and China, Japan and the Republic of Korea) is deemed merely a tail risk. And the three major global rating agencies have barely changed the sovereign debt ratings of Asian developing countries. However, the risk of a sovereign debt crisis remains serious for a few vulnerable economies, such as Sri Lanka.

To alleviate the external pressure, some countries have increased interest rates and tightened monetary policies, which, on the downside, will hold back economic recovery. Higher interest rates dent people's willingness to seek loans, which will hamper the recovery of domestic consumption.

Meanwhile, enterprises will face bigger risks of debt default and higher borrowing costs, thus having weaker capacities to invest. Governments will also bear greater burdens to pay debts, aggravating their fiscal vulnerabilities. All the above-mentioned factors will hinder the economic growth of developing countries in Asia.

In addition to interest rate increases, developing countries could consider utilizing other policy tools.

First is to strengthen regional currency cooperation. Asian countries could give full play to currency swap arrangements such as the Chiang Mai Initiative, and explore more bilateral and multilateral currency cooperation mechanisms to increase the resilience of Asian economies to shocks in the foreign exchange markets.

Second is to develop more capital regulation measures by introducing market-based instruments such as "Tobin tax "on financial transactions to deter speculative capital flows and stabilize foreign exchange markets.

Third is to enhance fiscal support. When countries tightened monetary policies to counter the effects of interest rate hikes by the Fed, fiscal measures can play a key role in mitigating the impacts a strong dollar has on vulnerable groups through transfer payments.

The author is an assistant research fellow at the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. The author contributed this article to China Watch, a think tank powered by China Daily.