What is *Dollar Index* and *why it's important in current uncertain economic & financial environment*?

What is the Dollar Index?

Dollar Index (often referred as to DXY) is a measure of the value of the U.S. dollar relative to a basket of 6 Foreign Currencies:

1. Euro (EUR) – 57%, the most heavily weighted component.
2. Japanese Yen (JPY)- 13.6%
3. British Pound (GBP)- 11.9%
4. Canadian Dollar (CAD)- 9.1%
5. Swedish Krona (SEK)- 4.2%
6. Swiss Franc (CHF)- 3.6%

a)????? The index was created in 1973, with a base value of 100, and it rises or falls as the dollar strengthens or weakens against these currencies.

b)????? It reached an all-time high in 1984 at nearly 165, and an all-time low of around 70 in 2007.

c)?????? In the years since then, the U.S. dollar index has been relatively range bound, fluctuating between 90 and 110.

Importance of the Dollar Index

1.?????? Indicator of U.S. Dollar Strength: The DXY shows how the dollar performs globally. A rising DXY indicates a stronger dollar, while a falling DXY suggests a weaker dollar.

2.?????? Global Trade and Commodities: Since many commodities, such as oil and gold, are priced in dollars, a strong dollar makes these goods more expensive for buyers using other currencies, potentially reducing demand and vice versa.

3.?????? Impact on Global Markets: A strong dollar often leads to tighter financial conditions globally, especially for emerging markets, as it increases the cost of servicing dollar-denominated debts.

4.?????? Stock market: When the index falls, the rupee appreciates, and the dollar weakens. As a result, investors in the US see an opportunity for higher returns in India, which leads to an inflow of Foreign Institutional Investment (FII). Due to heavy inflows, there is heavy buying in the overall market, and the stock market turns bullish - goes up

5.?????? Investor Sentiment: The DXY serves as a barometer of investor confidence. A rising index often correlates with risk-off sentiment, while a declining index may indicate risk-on behavior.

6.?????? Metal Price Change: If we look at historical data, we can conclude that gold prices are inversely related to the dollar index value. When the dollar index increases and the dollar strengthens, the gold price will fall. Gold gets imported into India in large quantities, and therefore it impacts the economy as a whole.

7.?????? Fuel Prices: India is the largest crude oil importer. The change in the dollar index affects crude oil prices and impacts us. When the dollar index rises, crude oil and other commodities become more expensive. It increases our import costs and widens our current account deficit. Also, it affects the profitability of the oil importers and refineries in India.

8.?????? Inflation: An increase in the dollar index makes the dollar strong and depreciates the Indian rupee's value. A weakened rupee makes imports costlier and impacts Indian company profitability due to increased production costs. Increased costs for companies mean companies have to increase the prices of goods and services, which leads to inflation. The overall Gross Domestic Product (GDP) is impacted and suffers a slowdown when the dollar strengthens

9.?????? Companies with Dollar-Denominated Debt: Some Indian companies have borrowed Dollar-denominated debt for cost-effectiveness. These companies are directly affected when the dollar rises. A strong dollar proves costly to companies with dollar-denominated debt as they have to shell out more in rupees to repay their debt. It impacts the company's profitability and might lead to a financial crunch

Importance in the Current Economic & Financial Environment

In today's uncertain global economic environment, the Dollar Index plays a critical role for the following reasons:

1.?????? Geopolitical Tensions and Safe-Haven Demand: With ongoing geopolitical uncertainties, including conflicts, trade tensions, and political instability, investors flock to the U.S. dollar as a safe-haven asset. This increases the DXY value.

2.?????? Monetary Policy Divergence: Major central banks are at varying stages of their monetary tightening or easing cycles. The Federal Reserve's policies significantly influence the dollar's strength. Higher U.S. interest rates attract foreign investments, driving up the DXY.

3.?????? Inflation and Recession Risks: Persistent inflation in developed and emerging markets keeps the spotlight on the dollar, as it offers a relatively stable store of value compared to weakening local currencies.

4.?????? Impact on Emerging Markets: A strong dollar creates challenges for emerging markets with large dollar-denominated debts, increasing their repayment burdens and causing potential liquidity crises.

5.?????? Commodity Price Volatility: Fluctuations in the DXY directly influence commodity prices, impacting global supply chains and inflation. For instance, a stronger dollar typically puts downward pressure on oil and gold prices.

6.????? Global Trade Balances: A higher DXY can hurt U.S. exports by making American goods more expensive abroad, widening the trade deficit, and potentially slowing U.S. economic growth.

7.?????? If Dollar Index is 107, USD is expensive by 7%, which hurts emerging economies mostly an expensive USD puts pressure on their financial markets.

8.????? If Dollar Index is at 90, its cheaper by 10% than its fair value, which will again hurt the emerging economy as majority exports goes to US.

Conclusion: The Dollar Index serves as a crucial benchmark for understanding the dynamics of the global economy and financial markets. For businesses, investors, and policymakers, monitoring the DXY is essential in navigating risks, formulating strategies, and making informed decisions in the current environment of heightened economic uncertainty.

CA Harshad Shah, Mumbai, India [email protected]