The US dollar’s strengthening last year to a 20-year high had major
implications for the global economy. We examine these spillovers from the
currency’s appreciation in our latest External Sector Report.
Building on recent
research
by Maurice Obstfeld and Haonan Zhou, we find that negative spillovers from
US dollar appreciations fall disproportionately on emerging market
economies when compared with smaller advanced economies.
In emerging market economies, a 10 percent US dollar appreciation, linked
to global financial market forces, decreases economic output by 1.9 percent
after one year, and this drag lingers for two and a half years. In
contrast, the negative effects in advanced economies are considerably
smaller in size, peaking at 0.6 percent after one quarter and are largely
gone in a year.
In emerging market economies, the effects of the strong dollar spread via
trade and financial channels. Their real trade volumes decline more
sharply, with imports dropping twice as much as exports. Emerging market
economies also tend to suffer disproportionately across other key metrics:
worsening credit availability, diminished capital inflows, tighter monetary
policy on impact, and bigger stock-market declines.
External sector implications
In addition, US dollar appreciations impact the current account, which
captures the change in saving-investment balances of countries.
As a share of gross domestic product, current account balances (saving
minus investment) increase in both emerging market economies and smaller
advanced economies, because of a depressed investment rate (there is no
clear systematic response for saving). However, the effect is larger and
more persistent for emerging market economies.
Exchange rate depreciation and accommodative monetary policy facilitate the
external sector adjustment for advanced economies. In emerging market
economies, fear of letting the exchange rate fluctuate and lack of monetary
policy accommodation magnify the increase in the current account.
There, the income compression channel—where lower income leads to a decline
in the purchase of imported items—plays a relatively bigger role. The
external sector adjustment in emerging market economies is further hindered
by their heightened exposure to the US dollar through trade invoicing and
liability denomination.
Policies
Emerging market economies with more anchored inflation expectations or more
flexible exchange rate regimes fare better.
More anchored inflation expectations help by allowing more freedom in the
response of monetary policy. After a depreciation, a country can run a
looser monetary policy if expectations are anchored. The result is a
shallower initial decline in real output. In turn, emerging market
economies with more flexible exchange rate regimes tend to enjoy a faster
economic recovery owing to a sizable immediate exchange rate depreciation.
Flexible exchange rate regimes can be
supported and facilitated by domestic financial market development that helps lessen the sensitivity of domestic borrowing conditions to the
exchange rate. Sustained longer-term commitments to improving fiscal and
monetary frameworks help anchor inflation
expectations. This includes ensuring a well-balanced mix of fiscal and monetary
policies, enhancing central bank independence, and continuing to strengthen
the effectiveness of communications.
Global effects
Global current account balances are calculated as the sum of absolute current account balances across
countries. It is a key metric in the IMF’s External Sector Report as it can
indicate increasing financial vulnerabilities and rising trade tensions.
Our research shows that a 10 percent appreciation is associated with a
decline in global current account balances by 0.4 percent of world GDP
after one year. The magnitude of the decline is economically significant,
as average global balances over the last two decades were about 3.5 percent
of world GDP, with a standard deviation of 0.7 percent.
The decline in global balances reflects a broad-based contraction in trade
in the presence of
dominant currency pricing, facilitated by narrowing commodity trade balances, given falling
commodity prices that have historically accompanied appreciations of the US
dollar.
In emerging market economies with severe financial frictions and balance
sheet vulnerabilities, macroprudential and capital flow management measures
could help mitigate negative cross-border spillovers.