US dollar's rise to 20-year high last year disproportionately affected emerging markets

IMF says greenback's appreciation had serious implications for the world economy, although the spillover effect on advanced economies was much smaller

The value of the US dollar has dropped sharply as inflation in the world's biggest economy continues to cool. Reuters
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Emerging markets bore the brunt of the US dollar’s appreciation last year as the greenback’s rise to a two-decade high disproportionately affected emerging economies, especially those with deep-rooted inflation and heavy debt burdens, the International Monetary Fund has said.

Although the strength of the US dollar had serious implications for the global economy, the spillover effect on the world’s advanced economies was much smaller, the IMF said in its latest External Sectors Report on Wednesday.

“Emerging markets and developing economies with pre-existing vulnerabilities such as high inflation and misaligned external positions experienced greater depreciation pressures,” the fund said.

The effects of the strong dollar reached emerging and developing economies mainly through the trade and financial sectors, IMF economists Rudolfs Bems and Racha Moussa wrote in a separate blog post.

“In emerging market economies, a 10 per cent US dollar appreciation, linked to global financial market forces, decreases economic output by 1.9 per cent after one year, and this drag [on the economy] lingers for two and a half years,” they said.

“In contrast, the negative effects in advanced economies are considerably smaller in size, peaking at 0.6 per cent after one quarter and are largely gone in a year.”

The value of the US currency appreciated sharply last year amid the US Federal Reserve’s aggressive push to increase interest rates.

As the Fed raised rates to fight inflation, overseas investors piled in seeking a higher rate of return, which drove the dollar to its highest level since 2002 in September last year.

However, the US dollar has weakened in recent months and the decline in its value is expected to persist after consumer prices in the world’s largest economy slowed in June.

Headline annual consumer price inflation fell to 3 per cent in June, down from 4 per cent in May, and has been dropping since hitting a peak at 9.1 per cent in June 2022.

The Fed aims to bring inflation down to its 2 per cent target and has raised interest rates by a combined 500 basis points over the past 16 months, their highest since 2007, shortly before the start of the 2008 global financial crisis.

The greenback last week fell to its lowest level in more than a year.

The US Dollar Index – a measure of the value of the dollar against a weighted basket of major currencies – is now down by about 3.3 per cent since the start of the year and is about 6.53 per cent lower over the past year.

When the dollar appreciates, real trade volumes in emerging markets decline at a sharper rate than they do in smaller advanced economies, with imports dropping twice as much as exports, the IMF economists said.

“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,” they said.

The rise in the value of the greenback also affects current account, which captures the change in the 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,” according to the IMF.

“However, the effect is larger and more persistent for emerging market economies.”

Global current account balances – defined as the sum of absolute values of current account deficits and surpluses – increased for the third consecutive year in 2022, the Washington-based fund said in the report.

This widening over the last three years reflects several factors, including the unequal impact of Covid-19 and the increase in commodity prices driven by the economic recovery in 2021 and later by supply concerns after Russia’s invasion of Ukraine in 2022.

“Over the medium term, global current account balances are expected to narrow as the impacts of the pandemic and Russia’s war in Ukraine recede,” the report said.

“However, several risks surround this outlook, including a renewed increase in commodity prices, a slower-than-expected recovery in China, or a slower fiscal consolidation in economies with current account deficits.”

The fund's research showed that a 10 per cent appreciation in the US currency is “associated with a decline in global current account balances by 0.4 per cent 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 per cent of world GDP, with a standard deviation of 0.7 per cent,” the fund’s economists wrote in the blog post.

“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.”

Updated: July 19, 2023, 1:00 PM