As the dollar slides, global central banks walk a monetary tightrope

The U.S. dollar is losing ground—and its decline is sending shockwaves through global financial markets, leaving central banks in a strategic bind. Should they let their currencies appreciate, risking export competitiveness, or consider devaluation, which could fuel inflation and provoke geopolitical backlash?

So far in 2025, the dollar index has fallen more than 9%, driven by growing uncertainty surrounding U.S. economic policy and a corresponding retreat from American assets, including Treasury bonds. According to Bank of America’s Global Fund Manager Survey, 61% of fund managers expect the dollar to decline further over the next year—the most bearish sentiment recorded in nearly two decades.

While a weaker dollar typically eases the burden on countries holding dollar-denominated debt and reduces import costs, the shift is a mixed blessing. For export-driven economies, an appreciating local currency can erode international competitiveness, especially at a time when renewed U.S. tariffs are already raising trade tensions.

Winners and Losers in the Currency Shuffle

The dollar’s retreat has led to notable gains for several safe-haven currencies. Since January, the Japanese yen has surged more than 10%, while the Swiss franc and the euro have risen about 11%. Other winners include the Mexican peso, up 5.5%, and the Canadian dollar, which has climbed over 4%. The Polish zloty and Russian ruble have also appreciated, with gains exceeding 9% and 22%, respectively.

However, not all currencies have followed suit. Some emerging market currencies, such as the Vietnamese dong, Indonesian rupiah, Turkish lira, and Chinese yuan, have seen new lows against the greenback before recovering slightly. These fluctuations reflect the volatility and vulnerability of markets that are more exposed to capital flight and inflation risks.

Room to Cut Rates? Not So Fast

A weakening dollar typically gives central banks more room to maneuver, particularly in terms of interest rate policy. Lower inflation from cheaper imports could allow some countries to cut rates to stimulate growth. “Most central banks would be happy to see 10%-20% declines in the U.S. dollar,” said Adam Button, chief currency analyst at ForexLive, noting that dollar strength has been a long-standing issue for many economies.

But caution prevails. Emerging markets are particularly wary of rate cuts, as many households and businesses carry significant U.S. dollar debt. Devaluing local currencies or cutting rates too aggressively could trigger capital outflows or increase the cost of foreign debt repayment.

For example, Indonesia’s central bank is unlikely to pursue major rate cuts due to recent volatility, while countries like South Korea and India may have more flexibility, according to Fitch Ratings’ director of economics, Alex Muscatelli.

The Fear of a Currency War

Central banks across Asia and other emerging markets are under pressure to strike a delicate balance. “Emerging markets face high inflation, debt, and capital flight risks, making devaluation dangerous,” said Wael Makarem, financial markets strategist at Exness. Any move to devalue a currency could be perceived as a competitive trade tactic—potentially inviting retaliation, especially from the United States.

Even in developed markets, central banks are wary of strong currencies. The Swiss National Bank, for instance, has long battled the effects of a robust franc, which hurts exports that make up over 75% of Switzerland’s GDP. Recent capital inflows during times of global uncertainty have further strengthened the franc, prompting discussions of drastic measures.

The European Central Bank has already taken advantage of easing inflation to cut rates by 25 basis points, signaling confidence that inflation will stay around its 2% target.

To Devalue or Not to Devalue

While technically feasible, currency devaluation remains a last resort for most central banks. Factors such as the size of foreign exchange reserves, exposure to foreign debt, trade balances, and sensitivity to import prices all influence whether a country can afford to devalue its currency without severe repercussions.

“Export-oriented countries with sufficient reserves and lower reliance on foreign debt would have more room to devalue – but even those are likely to tread carefully,” said Brendan McKenna, international economist and FX strategist at Wells Fargo.

Trade negotiations will also shape the direction of global currency policies. If ongoing talks lead to reduced tariffs and smoother trade relations, the incentive for central banks to weaken their currencies will diminish. But in a climate of rising protectionism, the risk of a global currency war cannot be ruled out.

“For now,” said McKenna, “it seems the preferred action is avoiding a currency war that would only add more instability to the local and global economy.”

As global markets watch the dollar slide, central banks must navigate a narrow path—balancing inflation, competitiveness, debt burdens, and geopolitical pressures. Whether they choose to adjust rates, intervene in markets, or simply wait and watch, one thing is clear: the era of dollar dominance may be facing its most serious test yet.