How Countries Should Respond to the Strong Dollar

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The dollar is at its highest level since 2000, having appreciated 22
percent against the yen, 13 percent against the Euro and 6 percent 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 dollar in international trade and finance.

While the US share in world merchandise exports has declined from 12
percent to 8 percent since 2000, the dollar’s share in world exports has
held around 40 percent. 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 percent dollar appreciation into inflation is 1 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.
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 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 percent 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

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.

Enhance resilience

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
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 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.

For the United States, despite the global fallout from a strong dollar and
tighter global financial conditions, monetary tightening remains the
appropriate policy while US inflation remains so far above target. Not
doing so would damage central bank credibility, de-anchor inflation
expectations, and necessitate even more tightening laterand greater
spillovers to the rest of the world.

That said, the Fed should keep in mind that large

spillovers are likely to spill back

into the US economy. In addition, as a global provider of the world’s safe
asset, the US could reactivate currency swap lines to eligible countries,
as it extended at the start of the pandemic, to provide an important safety
valve in times of currency market stress. These would usefully complement
dollar funding provided by the Fed’s standing

Foreign and International Monetary Authorities Repo Facility

The IMF will continue to work closely with our members to craft appropriate
macroeconomic policies in these turbulent times, relying on our

Integrated Policy Framework
. Beyond precautionary financing facilities available for eligible
countries, the IMF stands ready to extend our lending resources to member
countries experiencing balance of payments problems.

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