Dollar strength threatens to trigger a harmful loop in Asian emerging economies

A stronger dollar does not only affect foreign exchange markets, and there are signs that Asian emerging economies are being reminded of this in an uncomfortable way.

With 10-year Treasury yields near 5.30% and the dollar close to an 18-month high, investors currently have solid reasons to prefer US assets. The question of why to take on extra risk elsewhere when US government debt provides such attractive returns has a straightforward answer.

That is where the trouble starts. Capital flowing toward the US often means capital leaving emerging markets, and countries such as Thailand and Indonesia are caught in the middle.

The Thai baht illustrates this, with USD/THB up nearly 7% year to date. Beyond the dollar's rally, Thailand already faces a sluggish economic recovery and a tourism sector that has not fully bounced back.

Higher oil prices are adding to the strain. Thailand depends heavily on imported energy, and a weaker baht makes funding oil purchases in local currency more expensive. That threatens to squeeze households and businesses already dealing with rising costs.

Indonesia deals with a similar challenge, though a different set of domestic issues intensifies the pressure. The rupiah has faced headwinds from global capital flows, while concerns about fiscal policy and central bank independence at home give investors more reason to be cautious about the currency.

USD/IDR hit fresh record highs in June and has been drifting back toward those levels in recent weeks.

Indonesia's central bank has tried to ease the strain through currency stabilisation measures. However, with Treasury yields remaining elevated, keeping foreign capital interested in local assets is not easy.

That is not the whole story. This is where the situation can turn particularly problematic.

Consider an Indonesian company that owes $1 million in dollar-denominated debt. If the rupiah weakens, that debt suddenly costs more to repay in local currency, even if the company has not borrowed another dollar.

Add in higher inflation risks, more expensive imported goods and investors pulling money out over concerns about the economic outlook.

A vicious cycle then starts to develop. The currency weakens further, making dollar-denominated debt harder to service. In turn, nervous investors may move even more money out of the local currency and into the dollar.

That is the feedback loop.

The stronger dollar pressures emerging markets, and the resulting capital outflows can fuel even more demand for the greenback.

That said, the cycle can be stopped once it starts. Central banks can intervene, and factors such as stronger exports or improved investor confidence can offer some relief.

But with Treasury yields staying elevated, emerging market currencies may struggle to find a lasting reprieve without some relief from the dollar itself.