Lessons from the History of the King Dollar: "When to Beware of Financial Risks"

Five Periods of Dollar Strength Since 1980
Dollar Strength Accompanied by Financial Instability

[Asia Economy Reporter Ji Yeon-jin] The won-dollar exchange rate has surged close to 1,400 won this month, drawing attention to the financial risks associated with past strong dollar periods. Since 1980, there have been a total of five strong dollar phases, all accompanied by financial instability, prompting caution regarding the current "King Dollar" phenomenon.

According to Shinhan Investment Corp. on the 23rd, the first strong dollar phase coincided with interest rate hikes by the U.S. Federal Reserve (Fed). Paul Volcker, former Fed Chairman who took office in August 1979, raised the benchmark interest rate by 50 basis points immediately upon his appointment. The interest rate surged sharply from 10.5% before Volcker's appointment to over 20% by July 1981. Although inflation stabilized and the Fed's tightening stance eased from the second half of 1981, the nominal dollar index rose nearly 50% over six years, from 80 points in 1979 to 120 points in 1985. The first strong dollar era ended with the Plaza Accord in September 1985, which led to an artificial depreciation of the dollar's value.

First King Dollar: 50% rise over 5 years coinciding with U.S. Fed tightening in 1979

The second strong dollar appeared ten years after the Plaza Accord. The trigger was the reverse Plaza Accord in April 1995. Robert Rubin, former U.S. Treasury Secretary under the Clinton administration, argued that a strong dollar would support the development of new industries through capital inflows into the U.S. financial market and improve household purchasing power. The interests of Japan, which had to repatriate overseas assets to pay insurance claims following the Kobe earthquake in January 1995, also aligned. The yen carry trade, where investors borrowed low-interest yen to invest in countries with relatively higher interest rates, was unwound, causing the yen-dollar exchange rate to fall to around 80 yen. Consequently, the G7 finance ministers and central bank governors agreed to induce yen depreciation. Following the reverse Plaza Accord, the U.S. economy maintained stable growth due to capital inflows driven by the strong dollar. This strong dollar phase ended in 2001 with the collapse of the U.S. IT bubble and the Fed's interest rate cuts.

The third strong dollar phase was triggered by the financial crisis caused by the U.S. subprime mortgage crisis, accompanied by a preference for safe assets. Although the crisis began with the insolvency of U.S. financial institutions, financial institutions worldwide faced dollar liquidity shortages. The third strong dollar period was short, lasting less than a year, with a maximum increase below 20%, indicating limited strength. Liquidity that left overseas markets did not return to the U.S. The Fed's official introduction of quantitative easing in December 2008 and the start of Treasury bond purchases in March 2009 marked the turning point toward a weaker dollar.

The fourth strong dollar phase occurred from the second half of 2014 to early 2016. The aftermath of China's 4 trillion yuan fiscal stimulus led to prolonged global manufacturing downturns. While the U.S. sought exit strategies from monetary policy, including tapering and interest rate hike announcements, the Eurozone and Japan continued additional monetary easing, creating divergence in monetary policies among advanced economies that pressured the dollar higher. This strong dollar phase paused after the U.S. raised interest rates in December 2015 but postponed further hikes for a year due to increased economic downturn pressures. Additionally, China's supply-side reforms partially alleviated oversupply, reviving manufacturing and supporting a reversal in the dollar's value decline.

The background of the current fifth strong dollar phase is complex. Factors cited for the dollar's strength include differential impacts of the energy crisis by country, relative contraction in manufacturing, and divergence in monetary policies among advanced economies.

Strong dollar accompanied by financial instability... 1st strong dollar: Latin American debt crisis; 2nd: 1990 East Asian financial crisis; 4th: capital outflows from emerging markets due to China's yuan turbulence

Historically, strong dollar phases have been accompanied by financial instability. During the first strong dollar period, external debt crises occurred mainly in Latin American countries. Latin America experienced high growth averaging 6.2% annually from the 1960s to the 1980s, pursuing growth policies through expanded overseas borrowing, which led to a sharp increase in external debt relative to economic size. The external debt to nominal GNP ratio for Latin America as a whole reached 34.1%, with Brazil, Mexico, and Argentina all exceeding 30%. Amid this situation, U.S. monetary tightening caused the six-month LIBOR rate, a short-term borrowing cost for financial institutions, to rise nearly threefold from 6% in the mid-1970s to around 17% in 1981, sharply increasing borrowing costs. Governments abandoned fixed exchange rate systems, sharply devalued their currencies, and declared payment suspensions on external debts.

The second strong dollar phase saw the East Asian financial crisis, including South Korea. The crisis was driven by short-term external debt borrowing by financial institutions and corporations. From 1990 to 1996, net inflows of global private capital into emerging markets totaled $1.0549 trillion, causing economic overheating. Rising domestic currency values and overheating led to a surge in imports and worsening current account deficits. Concerns over fundamental economic damage intensified, and capital inflows due to liberalization were followed by capital outflows.

The third strong dollar phase was marked by the U.S.-originated financial crisis, causing dollar liquidity shortages. Overseas borrowing conditions worsened, and borrowing costs surged. However, emerging countries that had experienced foreign exchange crises accumulated foreign reserves based on current account surpluses in the 2000s to prepare for capital outflows. Additionally, central banks in the U.S., Europe, and Japan simultaneously lowered benchmark interest rates and implemented bailout measures, coordinating policies to prevent the crisis from spreading to specific countries' foreign exchange markets.

The fourth strong dollar phase saw increased volatility in emerging financial markets due to China's yuan turbulence. In August 2015, China devalued the yuan by raising the official exchange rate. Following the depreciation, capital outflows from China's financial markets accelerated. The financial account excluding reserve assets, which had averaged $52 billion quarterly inflows from 2009 to 2013, recorded outflows of $50.8 billion in Q2 2015, $140.9 billion in Q3, and $128.7 billion in Q4. Large-scale capital outflows continued until 2016, but financial market instability subsided as the strong dollar eased earlier.

Past large-scale capital outflows occurred during periods of declining global trade... August export growth slowdown

Researcher Ha Geon-hyung of Shinhan Investment said, "In the past, large-scale capital outflows occurred during periods when global trade stagnated or declined. South Korea's August exports slowed to single-digit growth compared to the previous year, and considering the price decline due to weak IT demand, export growth rates may stabilize or decline in the fourth quarter. Taking this into account, global trade is also expected to show a sluggish trend from the fourth quarter."

Researcher Ha added, "Compared to the past, households, corporations, and governments are all making efforts to manage external soundness, so the likelihood of a repeat external debt crisis is low. However, even countries like China in mid-2015, which had relatively low external debt ratios and overwhelming foreign exchange reserves, experienced increased financial market volatility due to capital outflows. We need to be cautious about financial market volatility expanding in export-oriented Asia and Europe," he emphasized.

This content was produced with the assistance of AI translation services.