The dollar is smiling. The world is not amused.

Some 20 years ago, two young economists devised a theory to explain the relationship between the value of the US dollar and global economic prospect. They intriguingly dubbed it "the dollar smile".

According to the theory, the value of the US dollar tends to climb when the country's economy is strong, or rather curiously, when the global economy is in recession. At either extreme of the smiling curve, dollar is deemed a desirable currency to hold, in order to reap the benefits of economic growth or to guard against risk.

This theory aptly captures what's happening now: the dollar is grinning amid gloomy global growth. The moral of this story, though, is that while a stronger dollar may delight Americans mightily, it is grim news for the rest of the world.

The dollar unchained

Since the end of World War II, the US dollar has been the most commonly held and widely used reserve currency for international trade and other transactions. Around half of international trade is invoiced in dollars; central banks around the world hold around 59 percent of their reserves in dollars; dollar-denominated debt outside the US keeps piling up, reaching $13.4 trillion as of mid-2022. Without doubt, the influence of the dollar goes far beyond that of a sovereign currency. It is a currency with incredible global reach, and the moves of the Federal Reserve are fervently followed by central banks, economists and investors around the world.

Many might be upset by what they saw: the value of the dollar has been soaring skywards in 2022. Compared to other major currencies, the greenback is up by more than 10 percent, reaching parity with the euro in July for the first time in nearly two decades. It is against such a backdrop that, on November 2, the Fed raised its benchmark interest rate by yet another 75 basis points — the fourth consecutive increase of such magnitude in a year and the Fed's sharpest rate hike in four decades.

Unprecedented monetary tightening supercharges the appreciation of the dollar. Combined with risk aversion sentiments of the market, it appears that a robust dollar is here to stay. The goal of the Fed's policy is to keep US domestic inflation at bay. What the Fed chose to ignore is that spillovers of a strong dollar leave the world with very little to smile for.

Beggar thy neighbor

Money-wise, 2022 is not an easy year for many economies. As countries' domestic currencies weaken against an ever-stronger dollar, it is cheaper for Americans to bring dinner to the table and fill their car with gas. But their relief comes at a cost.

Incendiary inflation is squeezing living standards in other parts of the world. Europe, in particular, under the double blow of dollar appreciation and the Ukraine situation, is experiencing a cost-of-living crisis. An executive at the UK's National Health Service (NHS) warned in a statement that many "could face the awful choice between skipping meals to heat their homes and having to live in cold, damp and very unpleasant conditions". Germany's annual producer price inflation, i.e. the price of goods leaving factories, reached its highest level in 73 years, feeding into consumer price inflation.

Worse still, a sovereign debt crisis is looming on the horizon. According to IMF's mid-year projection, 60 percent of low-income countries are in or at high risk of government debt distress. The developing world has felt the mounting pressure caused by expensive food, fuel and other commodities priced in dollars and their dollar-denominated debt.

Monetary tightening could leave a dent. High inflation has prompted central banks in other parts of the world to follow the Fed's lead. By now, the European Central Bank has raised rates by a combined 125 basis points and has not ruled out the possibility of further hikes. With policy tightening happening in sync and globally, their spillover effect could be magnified. This means developing countries and emerging markets will have to brace themselves for possibility of recession in 2023.

Who's the winner
Former US Treasury Secretary John Connally once candidly observed: "The dollar is our currency, but it's your problem". His words shed some light on why the dollar's predominance could be problematic for the rest of the world.

What the "dollar smile" reveals is a situation where the US is the winner at both ends of an economic cycle. Be it in boom or bust, the dollar can lock in economic benefits through prompting capital flight and exporting inflation. The history of the dollar as the world's most commonly used reserve currency is fraught with countless tales of desperate investors, bankrupt companies and insolvent governments, all at the mercy of even the slightest alteration of the Fed's policy.

Meanwhile, as woes of a stronger dollar are felt deeper in more parts of the world, steps are being taken to counter its supremacy. One macro trend is to diversify the world's reserve currency pool — the British pound, the Japanese yen and the euro all emerged as options at some point in history. In recent years, backed by China's extraordinary economic track record, the renminbi has grown to be a strong-performing, popular candidate.

Five decades after the collapse of the Bretton Woods system, a fair and effective foreign exchange system remains elusive. Much needs to be done to redress the existing imbalances. Fortunately, heartening news is on the horizon: with the emergence of new options, new norms and new technologies, the international system of foreign exchange might gravitate toward a more balanced, diverse and predictable one — a change that will benefit all.

Yi Xin is a Beijing-based observer.

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