When the US dollar gets stronger, the currency of emerging nations like Nigeria will be hurt. A stronger dollar relative to the Naira means the USD can now buy more Naira than before.
As the United States of America faces inflation, and the Federal Reserve tries to tame it by increasing interest rates to a range of 1.5% to 1.75%, the USD is getting stronger. USD has climbed about 13.6% in the last 365 days.
The US Dollar Index (DXY) that measures the value of US dollar VS Six currencies: Euro, Canadian dollar, British pound, Swiss franc, Japanese yen, and Swedish krona, is at 106.69 points and is at its highest point in three years. The higher the US dollar index, the more the dollar is appreciating.
Explainer: Possible sources of USD strength
Here are some of the factors responsible for the growth in the strength of USD:
Hawkish US Fed
Hawkish is an aggressive tone used to describe a statement by a central bank like the US Federal Reserve indicating that it may increase the interest rate.
In June 2022, the Consumer Price Index in the US rose to 9.1% and this is the highest inflation since 1981. The Fed is taking all necessary drastic measures to reduce inflation, including increasing interest rates.
There are speculations that the Fed will take more aggressive measures and interest rates may increase to 2.51% by the end of July and 3.23% by October.
Generally, increased interest rates increase the strength of a country’s currency. A hawkish US Fed will attract foreign investors who are willing to sell investments in their country’s denomination to buy fixed-income securities in USD.
This will increase the demand for USD, and also increase the exchange rate of USD to other currencies, especially small currencies like the Naira.
Russia conflict has caused many to seek safety in the USD
One of the reasons why Russia’s invasion of Ukraine is increasing the strength of dollars is that investors see U.S assets as safe haven, especially U.S treasury bonds which are renowned for remaining valuable even in times of market downturn or turbulence.
This is increasing the demand for U.S assets and U.S dollars, and in turn, strengthens the USD.
In February 2022, while the war against Ukraine by Russia was still a threat, Jake Sullivan, the White House national security adviser, warned of the possibility of Russia’s invasion of Ukraine and urged Americans in Ukraine to return to the US within the next two days.
The outcome of his statement was not just people trying to flee Ukraine for safety, but it also resulted in the price of US crude oil futures contracts increasing to $94.66. This increase was its highest since 2014.
Another reason why the war in Ukraine is increasing the strength of the USD, is investors believe that the war will have fewer adverse effects on the economy of America.
This is because the United States has less direct economic ties with Ukraine and Russia. Investors prefer to invest in countries or currencies that are less susceptible to the effect of the war.
Yield curve control in Japan
Yield curve control is a strategy used by central banks to control bond rates. This is done by buying back long-term bonds from the market to change the shape of the yield curve. This also pumps more money into the economy and increases inflation.
Japan has adopted the yield curve control policy to increase inflation to 2% after the economy of the country has suffered from deflation for decades. The Bank of Japan (BOJ) intends to keep 10-year government bond yields at zero with 25 basis points, and as of early 2022, Japan bought more bonds at 0.25bps.
After several years of deflation, Japan is finally seeing some inflation. In April 2022 the country saw an increase in inflation to 2.1%. However, this is most likely not the kind of inflation the Bank of Japan envisaged as the strength of the Japanese Yen is weakening.
As the American Federal Reserve increases interest rates, investors are now more attracted to U.S dollar-denominated assets because they want higher returns, and this is giving the dollar more strength over Yen.
In past years, Japan used to appreciate a weak Yen as it was beneficial to exporters, especially its automobile Giant Toyota as they made more profits when they sell abroad, but as a food and energy importer, Japan now has a weak currency to pay for the surging prices of these commodities.
Delay in hiking interest rate by the European Central Bank despite soaring inflation in Europe
In June 2022, inflation in the Euro zone rose to an annual rate of 8.6%. People across the 19 countries that use the Euro have seen an increase in the price of everything.
Investors have been observing the inflation and expecting the European Central Bank to take drastic measures to control inflation as the U.S Federal Reserve is doing, but the European Central Bank is not in a hurry to increase interest rates.
Christine Lagarde, the President of the European Central Bank, has warned that inflation in the Euro zone is a ‘different beast’ from that in America.
She said it was because in America, inflation is caused by a tense labour market, while that of the Euro zone is caused by an increase in oil prices as a result of the war in Ukraine and sanctions on Russia. She has also said that any rate hike will come weeks or months after the end of bond purchases.
While the European Central Bank delays in hiking Interest rates, and the Fed is hawkish, the euro continues to weaken against the dollar.
China’s Zero Covid policies
In a bid to prevent the spread of the Coronavirus, China has adopted zero Covid Policies. Workers in Beijing have been forced to work from home, and over 22 million residents of the city were forced to stay indoors. Other cities like Shanghai, and Wuhu are also facing strict measures.
According to economists, up to 50% of China’s total output has been affected by the strict lockdown measures. The international monetary fund has reduced its forecast for China’s GDP growth for 2022 to 4.4%.
The head of the China program at the Peterson Institute for International Economics in Washington DC, Mary Lovely has warned against slow growth but increasing unemployment in the country. Despite some ease in the Covid’19 lockdown measures, China’s Yuan is depreciating and is now about 5% down against the dollar.
As the U.S Federal Reserve increases its interest rate, investors are also becoming less attracted to Chinese assets and won’t mind selling their Chinese assets to buy the more attractive dollar-denominated assets.
The Implications for Nigerian investors
Here are some of the implications of a strong dollar for Nigerian investors.
Higher cost of importation
Nigeria is well known for the importation of foreign products. The gadgets, cars, machinery, fuel, chemical products, and even some of the food consumed in Nigeria come from other countries.
According to the National Bureau of Statistics, Nigeria’s total imports is N7.1 billion and exports is lower at N5.9 billion. For a country so dependent on international goods, a strong dollar means a higher cost of importation.
The vicarious outcome of a stronger dollar and higher cost of importation will be an increase in inflation in the country as investors will also have to sell at higher prices to cover up their importation cost.
Analysts speculate that if the US Fed continues to increase the interest rate, and Naira weakens more than it is, the official CBN USD/NGN exchange rate may go higher.
Impact on investors & traders
The price of equities in the stock market work based on the law of demand and supply. When more people are interested in buying a stock, the price increases, and when there are fewer people interested, the price reduces.
Many Nigerian companies also import machinery and raw materials so their cost of doing business increases and it affects their productivity and profit. A company posting lower profits may see its share price drop as investors lose confidence.
On the other hand, the lower currency could also benefit the companies that export goods & services outside Nigeria.
Nigeria also has a lot of forex traders who trade forex via online retail brokers and speculate on currencies. A strong dollar means they spend more Naira to buy a dollar to fund trading account, thus depleting any gains they make. It also makes fees and commissions these traders have to pay to retail forex brokers more expensive when converted to Naira.
Another effect of the strong US Dollar is funding from overseas. Many new startups no longer raise capital from the Nigeria Stock Exchange and they now prefer to raise funds from venture capitalists overseas because of the stronger currency.
In the Eye of the storm
You need to keep an eye on the strength of dollars while making financial decisions. There is also need to manage risk when investing by using futures contracts available on the NGX exchange. They will enable you lock in today’s price for use tomorrow.