A stronger dollar complicates an already-uncertain credit outlook. It also reintroduces a credit factor that has been largely absent on a global basis for close to 20 years, and beyond in many cases. The greenback will now act as both a headwind and a tailwind to issuers differentiated by region and sector. S&P Global Ratings has looked at five ways that a stronger dollar could affect economic and credit performances.

Asia-Pacific: Accelerates Capital Outflows; Sudden Large Devaluation Unlikely

Hawkish U.S. Fed interest rate increases have triggered accelerated capital outflows.  Asia-Pacific is usually a net exporter of capital, with financial capital outflows (excluding foreign direct investment) tending to exceed financial inflows. But the rise in U.S. interest rates has hastened outflows. Net financial outflows in the first half of 2022 rose by US$99 billion in six large Asian economies compared with a year earlier (see "Foreign Reserves In Asia's Emerging Markets Are Strained," Aug. 22, 2022).

In China, net financial outflows rose by US$45 billion from a year ago.   In India, net inflows of US$28 billion in the first half of 2021 turned into net outflows of US$19 billion. While net financial outflows eased in July and August, they likely picked up again in September, as expectations about further U.S. interest rate hikes were adjusted upward again.

Combined with the impact of higher energy and commodity prices on the current accounts of net energy importers, the outflows are straining foreign exchange (FX) markets.   Depreciation has absorbed much of this pressure, especially in Japan, New Zealand, the Philippines, South Korea, and Taiwan. But foreign reserves have fallen nonetheless; in some cases, even after adjusting for large valuation changes. In China, foreign reserves declined by US$203 billion in the year through August, compared with a negative contribution from valuation changes of US$211 billion. In South Korea, valuation changes explained almost all the US$27 billion fall in reserves in that period. But in India, the decrease in foreign reserves of US$59 billion through July greatly exceeded the negative valuation change impact of US$20 billion, pointing to sizable intervention by the Reserve Bank of India (RBI) to support the rupee.

With U.S. interest rates set to rise more, pressure on Asia-Pacific forex markets will persist but may be uneven.   Some central banks tighten heavily and others retain accommodative stances--especially where inflation is relatively low. Indeed, of all Asia-Pacific currencies, the Japanese yen has weakened the most this year (see chart 1), as the Bank of Japan holds on to its highly accommodative monetary policy. China's monetary policy is likely to remain accommodative amid weak growth. The authorities there suggest monetary easing is constrained by concerns about capital flows and have taken some steps to support the renminbi.

Policy regimes in Asian emerging markets have improved in important ways, making a sudden freeze of capital markets or large devaluations and financial crises less likely.   Broadly flexible exchange rates have absorbed most of the external pressure--central banks have largely abstained from propping up currencies by selling forex reserves. Indeed, given still-reasonable reserve adequacy and mostly flexible exchange rates, we don't expect foreign reserves to decline to dangerously low levels any time soon in the major Asian emerging markets, although this is different in economies such as Sri Lanka and Pakistan. Macroeconomic policy has generally been more cautious in recent years than before the 1997 crisis. In addition, a much larger share of government borrowing is now in domestic currencies, reducing the impact of currency weakening on debt servicing.

However, rising current account deficits in net energy-importing Asian countries make them vulnerable to changes in sentiment and reversals of capital flows.   External deficits have risen significantly in India and South Korea and, especially, in Thailand and the Philippines. Even though energy prices have eased from earlier peaks, policymakers in several economies may have to tighten fiscal and monetary policy to reduce external vulnerability, especially as demand for their exports is likely to slow.

U.S. rate hikes and a stronger dollar complicate the offshore financing picture.   Outflows and currency depreciation, triggered by unfavorable benchmark yields differentials, mean external funding costs continue to rise. This is compounding the significant increases in Asian dollar bond yields, which have already occurred year to date--over 310 basis points (bps) for investment-grade and over 750 bps for speculative-grade issues. In turn, this makes access to financing or refinancing more difficult, with offshore speculative-grade markets effectively closed.

Chart 1

Europe: Short-Term Pain, Potentially Long-Term Gains

Rate differentials are not the only reason for the sharp depreciation of the euro against the dollar (see chart 2).   Because the U.S. economy is not a large net importer of energy and food, unlike all European economies, it is less exposed to the double shock on energy and food prices currently weighing on European economies. The geopolitical shock caused by the war in Ukraine also supports traditional safe haven currencies such as the U.S. dollar. The Swiss franc, another traditional destination for global capital, has depreciated less against the dollar than the euro or the pound sterling.

The depreciation of the euro against the dollar in one year has probably added half a point of inflation in the eurozone.   A depreciation of the currency is not automatically a bad thing for an economy. It depends on the context and the economy. In the current context of high-cost energy, which is mainly bought abroad by Europe in U.S. dollars, depreciation of European currencies is bad in the short term, as it fuels inflation and makes it more difficult for the European Central Bank (ECB) to stabilize prices. According to our models, the 16% depreciation of the euro against the dollar in the past 12 months has probably added half a point of inflation in the eurozone and reduced household consumption by the same amount.

In contrast, and over a longer time frame, a stronger dollar may improve the competitiveness of European exports   European economies are trade-oriented economies, with exports often accounting for more than 40% of GDP. A depreciation of their currency with respect to the U.S. economy, which is the main destination for European exports of goods and services, is not necessarily a bad thing. According to economic literature (see "Global Trade Flows: Revisiting the Exchange Rate Elasticities (banque-france.fr), Working Paper N°608," November 2016), the trade balance of the eurozone economy first deteriorates following a currency depreciation due to the immediate rise in import prices, then improves due to the improved competitiveness of exports.

In the face of a sudden depreciation in the exchange rate, the trade balance follows a J-shaped curve.   However, while competitiveness may improve over the next 18-24 months, the moderate growth prospects for the U.S. economy probably mean that over the same period, benefits of currency depreciations for European economies will be limited.

Speed of depreciation triggers increased volatility and contributes to tighter European financing conditions.   Persistent high inflation and the ongoing Russian-Ukraine conflict are contributing to a sharp tightening in financing conditions. The speed of depreciation of the euro against the U.S. dollar--below parity for the first time in 20 years--has contributed to increased volatility.

Chart 2

U.S. Corporates: Sector Impact Varies; Technology And Chemicals Most Exposed To Non-Dollar Revenue

A stronger dollar creates headwinds for U.S. corporates reliant upon overseas markets.   While a stronger dollar tempers input costs for U.S. companies that import raw materials, at the same time it can create challenges for American companies that rely on foreign markets for the bulk of their sales. They may suffer declining foreign profits when foreign currencies are converted into U.S. dollars through the "translation effect." For example, large global auto makers have significant currency exposures to the Brazilian real, British pound, Chinese renminbi, euro, and Mexican peso. For this sector, weakening of these currencies against the dollar resulted in a year-over-year decrease in sales of roughly 7%-10% in the first half of 2022.

From an investor perspective, the translation effect is problematic because it can obscure any fundamental change in performance.   Although many companies publish reports to address this situation, multinationals could also see shrinking EBITDA margins if they delay raising prices (relative to costs) to protect market share. In addition, for companies whose cost base is largely U.S. dollar-denominated, their competitiveness could suffer as purchasing power erodes for international customers and foreign competitors' goods and services become more attractive for U.S. consumers.

Exposure of U.S. corporates to overseas revenue differs materially across sectors.   Based on a sample of about 1,000 U.S. entities that we rate for which the U.S. versus non-U.S. revenue breakdown is available, sectors such as technology, chemicals, capital goods, health care, and autos have, on average, more revenue exposure to countries outside the U.S. By contrast, real estate, telecom, engineering and construction, midstream energy, utilities, and homebuilders and developers are more domestically driven (see chart 3).

Chart 3

Meanwhile, other macroeconomic trends can sometimes outweigh what is transpiring in currency markets.   And beyond the strong dollar, many multinationals are dealing with persistent supply disruptions, widespread inflationary pressures, and geopolitical uncertainty.

Technology companies have the highest exposure to non-U.S. currencies.  Many companies are multinational, and the dollar's strength is pressuring revenue for many U.S. firms. While many have either natural hedges or contractual hedges, these are rarely 100% effective, so the stronger dollar is a negative. If the dollar stays strong over the medium term, we expect tech companies to raise prices on products for sale overseas, which could lead to lower demand.

The impact for autos is also relatively high, given foreign markets' importance for sales.   As mentioned above, large global auto makers have already faced currency translation headwinds in the first half of the year. Most auto suppliers mitigate exchange-rate risk by establishing local production facilities and related supply-chain participants in the markets they serve; by invoicing customers in the same currency as the source of the products; and by investing in foreign markets through local-currency loans. A few issuers regularly enter forward currency contracts, cross-currency swaps, and foreign currency-denominated debt designated as net investment hedges, to reduce exposure to translation risk.

Other notable sectors with a high level of non-dollar revenue include chemicals.   Chemicals is likely to remain competitive so long as energy-price differentials continue to favor the U.S., even as some producers have meaningful sales in global markets.

For capital products, the strong dollar provides good protection for imported inputs.   That said, weak currencies in major Europe and Asia markets are compounding revenue pressures from relatively weak underlying business conditions.

For agribusiness, a subsector of consumer products, the stronger dollar is typically a net positive.   It incentivizes farmers in other regions to sell their crops faster because commodities are priced in dollars, which is good for grain traders. It also makes American exports less competitive, depressing local on-farm U.S. prices and benefitting U.S. processors and other local grain consumers.

Commodities: In A Dollar-Denominated Industry, Concerns Regarding Global Demand Are More Pressing Than Dollar-Driven Pricing Pressure

The macroeconomic context and reasons for the dollar's strength may be more important than direct price movements.   With most commodities priced in dollars, benchmark prices often experience downward pressure as the dollar rises, all else being equal. However, this correlation is sometimes broken and rarely one to one (see chart 4). The macroeconomic outlook may be more important. Recession risk dampens demand expectations, increasing downward pressure on commodity prices. The impact of the stronger dollar on companies and countries also depends on their own currency and mix of debt denominations. A commodity producer's local costs likely decline in dollar terms and dollar-linked revenue rise when reported in a local currency.

Chart 4

Emerging market entities are often seen as most exposed to dollar and other currency fluctuations, and historical examples inform investor confidence or lack of it.   Perhaps ironically, the direct impact of a stronger dollar, in isolation, may be greatest for those commodity companies operating in extractive industries in the U.S. Assuming flat volumes, a stronger dollar implies lower revenue, but unchanged costs and debt. Profitability and credit metrics weaken, absent corrective actions. Margins and metrics also weaken where costs are denominated in currencies that have depreciated compared with the dollar. That said, this currency depreciation can be a natural hedge, partly offsetting the impact of lower commodity revenue. This is particularly true if the debt is also denominated in weaker currencies.

The overall credit consequences of a stronger dollar over several quarters or years are broader than this one-dimensional impact suggests.   This multifaceted impact of dollar strength is critical for emerging market players, due to domestic inflation and access to funding. In particular, the prevailing strength of the dollar does not signal robust U.S. growth; rather, it is due to its haven status and interest-rate differentials. The weaker outlook for major economies, and especially China, is a negative factor for commodities demand and prices in general--even as some supply-chain disruptions and restocking continue. Absent very sharp corrections, actual currency trends over weeks and months may be less important for credit than the flexibility to cope with and adapt to both currency and commodity price fluctuations through cycles.

Many commodity producers have reduced debt in recent years and continue to benefit from relatively strong credit metrics, despite the recent moderation in many energy and metal prices from cyclical or recent highs.   The headroom at respective ratings may prove important as the U.S. dollar has strengthened and is likely to remain strong. For countries and companies that have significant unhedged U.S. dollar-denominated debt, any debt pay-down achieved to date is unwinding with every step-up in the dollar. Financial covenants can also be tripped, especially if exchange rates move significantly.

Our ratings are typically consistent with a moderate range of commodity prices or currency assumptions.   Volatility is inherent for industries exposed to commodities, even more so when currencies are also key variables. Ratings that have a significant link to or reliance on commodities usually don't assume historically high or low prices will persist indefinitely, even if mean-reversion can take time. Similarly, the impact of a stronger dollar has to be factored into our near-term view, especially for lower ratings or those issuers with weaker liquidity, but investment-grade ratings are generally more resilient. While individual and aggregate impacts are difficult to forecast, the consequences for a specific rating are often determined by the headroom or positioning of the entity within rating thresholds.

Refinancing Risk Is Complicated, Particularly In Emerging Markets

From a refinancing perspective--the risk of a stronger dollar is weighted to the downside.   A stronger dollar will benefit U.S. corporates with debt denominated in other currencies, namely euro and sterling. But this cohort is likely to be limited and primarily composed of larger investment-grade multinationals. The real risk lies among non-U.S. issuers, which have a large amount of dollar-denominated debt outstanding. This adds a significant hurdle to issuers already dealing with tightening global financing conditions in the face of rising rates, geopolitical tensions, and a fading credit outlook.

From a regional perspective, emerging markets look by far the most vulnerable.   While 30% of European corporate debt maturing through 2023 is dollar-denominated, the exposure shoots up for emerging markets. Some 81% of corporate debt (instruments with a global scale rating from S&P Global Ratings) in these markets is denominated in U.S. dollars. This may present a significant problem for issuers that do not have dollar revenues or are not adequately hedged against exchange rate risk.

Rating distribution is another indicative risk.  We estimate that 25% of dollar-denominated emerging market debt due through 2023, and around 28%% through 2027, is rated at speculative grade (see chart 5). A stronger dollar increases the pressure on a lower-rated issuer's ability to meet interest payments. It adds significant refinancing risk for speculative-grade issuers already grappling with primary markets that are selective at best and shuttered at worst.

Chart 5

Despite obvious challenges, a review of sector breakdowns adds an air of positivity.   Similarly to the pandemic, the impact will be uneven, with some sectors better-placed to withstand the increased costs associated with dollar debt. Within emerging markets, the sector with the largest amount of dollar-denominated debt is financial institutions, with diverging paths for emerging market banks and nonbank financial institutions (NBFI). Emerging market banks will be far from immune to weakening macroeconomic conditions. That said, higher interest rates underpinning net interest margins should support profitability so long as asset quality does not deteriorate sharply. By contrast, emerging market NBFIs are more vulnerable than banks to disruptions in funding access, given challenging operating conditions.

The second-largest sector, oil and gas, has largely benefited from the ongoing energy crisis triggered by the Russian-Ukraine conflict.   Commodity prices will likely remain volatile, with the macroeconomic outlook across developed countries a key influencer of demand. Elevated revenue and profitability will likely assist many issuers facing near-term dollar-denominated refinancing risk.

Related Research

• No Easy Way To Correct Outsized Dollar Strength, Oct. 7, 2022
• Global Credit Conditions Q4 2022: Darkening Horizons, Sept. 29, 2022
• Regional Refinancing: U.S., Europe, and Emerging Markets, Sept. 8, 2022
• Foreign Reserves In Asia's Emerging Markets Are Strained, Aug. 22, 2022
• S&P Global Ratings' Metal Price Assumptions: Prices Settle Lower As Slowdown Fears Grow, Aug. 8, 2022
• S&P Global Ratings Raises European Gas Price Assumptions On Uncertain Supply, Aug. 1, 2022