Such a sharp strengthening of the dollar in a matter of months has sizeable macroeconomic implications for almost all countries, given the dominance of the dollar in international trade and finance.
While the US share in world merchandise exports has declined from 12% to 8% 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 1%.
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 loans 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 markets and many low-income countries that are already at a high risk of debt distress.
SO, WHAT THEN?
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 favourable 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 signalled 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 emerging markets and developing economies 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.
Fiscal policy should be used to support the most vulnerable without jeopardising 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.
ENHANCE RESILIENCE
