The US dollar is at its highest level since 2000, having
appreciated 22% against yen, 13% against the euro and 6% against emerging
market currencies since the start of this year. Such a sharp strengthening of
the dollar in a matter of months has sizable macroeconomic implications for
almost all countries, given the dominance of the greenback in international
trade and finance.
While the US share in world merchandise exports has declined
to 8% from 12% since 2000, the dollar’s share in world exports has held around
40%. For many countries fighting to bring down inflation, the weakening of
their currencies relative to the dollar has made the fight harder. On average,
the estimated pass through of a 10% dollar appreciation into inflation is one percent.
Such pressures are especially acute in emerging markets, reflecting their
higher import dependency and greater share of dollar-invoiced imports compared
with advanced economies.
The dollar’s appreciation also is reverberating through
balance sheets around the world. Approximately half of all cross-border
loan and international debt securities are denominated in US dollars. While
emerging market governments have made progress in issuing debt in their own
currency, their private corporate sectors have high levels of
dollar-denominated debt. As world interest rates rise, financial conditions
have tightened considerably for many countries. A stronger dollar only
compounds these pressures, especially for some emerging market and many
low-income countries that are already at a high risk of debt distress.
In
these circumstances, should countries actively support their currencies?
Several countries are resorting to foreign exchange interventions. Total
foreign reserves held by emerging market and developing economies fell by more
than 6% in the first seven months of this year.
The
appropriate policy response to depreciation pressures requires a focus on the
drivers of the exchange rate change and on signs of market disruptions.
Specifically, foreign exchange intervention should not substitute for warranted
adjustment to macroeconomic policies. There is a role for intervening on a
temporary basis when currency movements substantially raise financial stability
risks and/or significantly disrupt the central bank’s ability to maintain price
stability.
As of now, economic fundamentals are a major factor in the
appreciation of the dollar, rapidly rising US interest rates and a more
favorable terms of trade a measure of prices for a country’s exports relative
to its imports for the US caused by the energy crisis.
Fighting a historic increase in inflation, the Federal Reserve
has embarked on a rapid tightening path for policy interest rates.
The European Central Bank, while also facing broad-based
inflation, has signaled a shallower path for their policy rates, out of concern
that the energy crisis will cause an economic downturn.
Meanwhile, low inflation in Japan and China has allowed
their central banks to buck the global tightening trend.
The massive terms of trade shock triggered by Russia’s
invasion of Ukraine is the second major driver behind the dollar’s strength.
The euro area is highly reliant on energy imports, in particular natural gas
from Russia. The surge in gas prices has brought its terms of trade to the
lowest level in the history of the shared currency.
As for emerging markets and developing economies beyond China,
many were ahead in the global monetary tightening cycle—perhaps in part out of
concern about their dollar exchange rate—while commodity exporting EMDEs
experienced a positive terms-of-trade shock. Consequently, exchange-rate
pressures for the average emerging market economy have been less severe than
for advanced economies, and some, such as Brazil and Mexico, have even
appreciated.
Given the significant role of fundamental drivers, the
appropriate response is to allow the exchange rate to adjust, while using
monetary policy to keep inflation close to its target.
The
higher price of imported goods will help bring about the necessary adjustment
to the fundamental shocks as it reduces imports, which in turn helps with
reducing the buildup of external debt.
Fiscal policy should be used to support the most vulnerable
without jeopardizing inflation goals.
Additional steps are also needed to address several downside
risks on the horizon. Importantly, we could see far greater turmoil in
financial markets, including a sudden loss of appetite for emerging market
assets that prompts large capital outflows, as investors retreat to safe
assets.
In this
fragile environment, it is prudent to enhance resilience. Although emerging
market central banks have stockpiled dollar reserves in recent years,
reflecting lessons learned from earlier crises, these buffers are limited and
should be used prudently.
Countries must preserve vital foreign reserves to deal with
potentially worse outflows and turmoil in the future. Those that are able
should reinstate swap lines with advanced-economy central banks.
Countries with sound economic policies in need
of addressing moderate vulnerabilities should proactively avail themselves
of the IMF’s precautionary lines to meet future liquidity needs.
Those with large foreign-currency debts should reduce
foreign-exchange mismatches by using capital-flow management or macro-prudential
policies, in addition to debt management operations to smooth repayment
profiles.
In addition to fundamentals, with financial markets
tightening, some countries are seeing signs of market disruptions such as
rising currency hedging premia and local currency financing premia.
Severe
disruptions in shallow currency markets would trigger large changes in these
premia, potentially causing macroeconomic and financial instability.
In such cases, temporary foreign exchange intervention may
be appropriate. This can also help prevent adverse financial amplification if a
large depreciation increases financial stability risks, such as corporate
defaults, due to mismatches.
Finally,
temporary intervention can also support monetary policy in the rare
circumstances where a large exchange rate depreciation could de-anchor
inflation expectations, and monetary policy alone cannot restore price
stability.
