The dollar is at its highest level since 2000, having appreciated 22% against the yen, 13% against the euro and 6% against emerging market currencies since the start of this year. Such a strengthening of the dollar in a few months has important macroeconomic implications for almost all countries, given the dominance of the dollar in international trade and finance.
While the United States’ share of world merchandise exports has fallen from 12% to 8% since 2000, the dollar’s share of world exports has remained at around 40%. For many countries struggling to bring down inflation, the weakening of their currency against the dollar has made the fight harder. On average, the estimated impact of a 10% dollar appreciation on inflation is 1%. These pressures are particularly acute in emerging markets, reflecting their greater reliance on imports and a larger share of imports priced in dollars compared to advanced economies.
The appreciation of the dollar is also affecting balance sheets around the world.
About 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 companies have high levels of dollar-denominated debt. With rising global interest rates, financial conditions have tightened considerably for many countries. A stronger dollar only adds to these pressures, especially for some emerging markets and many low-income countries that are already at high risk of debt distress.
Under these conditions, should countries actively support their currencies? Several countries resort to foreign exchange interventions. Total foreign exchange reserves held by emerging and developing economies fell by more than 6% in the first seven months of this year.
The appropriate policy response to depreciation pressures requires focusing on the drivers of exchange rate movement and signs of market disruptions. More specifically, foreign exchange intervention should not substitute for a justified adjustment of macroeconomic policies. Temporary intervention is appropriate when exchange rate movements significantly increase risks to financial stability and/or significantly disrupt the central bank’s ability to maintain price stability.
At present, economic fundamentals are a major factor in the appreciation of the dollar: rapidly rising U.S. interest rates and more favorable terms of trade – a measure of a country’s export prices per compared to its imports – for the United States, caused by the energy crisis. Fighting against a historic rise in inflation, the Federal Reserve embarked on a course of rapid tightening of key interest rates. The European Central Bank, while also facing widespread inflation, signaled a shallower trajectory for its key rates, fearing that the energy crisis could cause an economic slowdown. Meanwhile, low inflation in Japan and China allowed their central banks to counter the global tightening trend.
The massive terms-of-trade shock triggered by Russia’s invasion of Ukraine is the second major driver of dollar strength. The Eurozone is heavily dependent on energy imports, particularly natural gas from Russia. Soaring gas prices have taken its terms of trade to the lowest level in the history of the common currency.
As for emerging markets and developing economies beyond China, many were ahead of the global monetary tightening cycle – perhaps in part due to concerns over their dollar exchange rate – while commodity-exporting EMDEs suffered a positive terms-of-trade shock. As a result, 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 increased.
Given the important 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 provide the necessary adjustment to fundamental shocks as it reduces imports, which in turn helps reduce the accumulation of external debt. Fiscal policy should be used to support the most vulnerable without compromising inflation targets.
Additional measures are also needed to address several downside risks looming on the horizon. Importantly, we could see much greater turbulence in financial markets, including a sudden loss of appetite for emerging market assets that leads to large capital outflows, as investors retreat to safe assets.
In this fragile environment, it is prudent to build resilience. Although central banks in emerging markets have accumulated dollar reserves in recent years, reflecting lessons learned from previous crises, these reserves are limited and should be used with caution.
Countries need to preserve vital foreign exchange reserves to weather potentially worse outflows and turbulence in the future. Those who can should restore swap lines with central banks in advanced economies. Countries with sound economic policies that need to address moderate vulnerabilities should proactively avail themselves of IMF precautionary lines to meet their future liquidity needs. Those with large foreign currency debts should reduce exchange rate mismatches by using capital flow management or macroprudential 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 premiums and local currency funding premiums. Severe disruptions in shallow foreign exchange markets would cause large shifts in these premiums, which could lead to macroeconomic and financial instability.
In such cases, temporary foreign exchange intervention may be appropriate. It can also help prevent adverse financial amplification if a large depreciation increases financial stability risks, such as business failures, due to mismatches. Finally, temporary intervention can also support monetary policy in the rare circumstances where a sharp depreciation of the exchange rate could unanchor inflation expectations, and where monetary policy alone cannot restore price stability.
For the US, despite the global fallout from a strong dollar and tighter global financial conditions, monetary tightening remains the appropriate policy as US inflation so far remains above target. Failure to do so would damage the credibility of the central bank, unanchor inflation expectations and necessitate even more tightening down the road.—and greater spillovers to the rest of the world.
That said, the Fed should keep in mind that there are significant ripple effects that are likely to ripple through the US economy. In addition, as the global provider of the global safe asset, the United States could reactivate currency swap lines to eligible countries, as extended at the start of the pandemic, to provide a important safety valve in times of stress on the foreign exchange market. These would usefully supplement the dollar funding provided by the Fed’s permanent foreign and international monetary authority repo facility.
The IMF will continue to work closely with its members to develop appropriate macroeconomic policies in these turbulent times, building on our integrated policy framework. Beyond the precautionary financing facilities available to eligible countries, the IMF stands ready to extend its lending resources to member countries experiencing balance of payments problems.