## CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE

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### Introduction: context and research questions
- During the post–Bretton Woods era of flexible exchange rates, the US dollar has followed pronounced decade-long swings; the most recent sharp US dollar appreciation in 2021–22 is part of these oscillations.
- The chapter focuses on external sector implications of the “global dollar cycle” for a sample of emerging markets and small advanced economies.
- Research questions:
  - Are there systematic external sector spillovers from the global dollar cycle?
  - Do effects differ across countries, and if so, what explains the heterogeneity?
  - What are the implications for global current account balances?

### Methodology and identification
- Empirical approach:
  - State-dependent local projections (LP) methodology, following Obstfeld and Zhou (2023).
  - Main regressor: first difference of a trade-weighted US dollar index against currencies of major advanced economies.
  - Simultaneous controls for: monetary policy developments, broader US financial conditions, economic activity trends in the rest of the world, and lagged change in the US dollar index.
  - Residual after controlling for established factors is labeled the “global dollar cycle.”
  - Excludes countries with a weight in the index greater than 4 percent.
  - Sample: 15 advanced and 19 emerging market economies (retains advanced economies with weight < 4 percent in 2020).
- Identification of financial shocks:
  - Identification by exclusion linking financial market forces to the residual not explained by established exchange rate determinants.
  - Focus on correlates such as UIP deviations and the global financial cycle.
- Model-based interpretation:
  - Flexible System of Global Models (FSGM; Andrle and others 2015) used to simulate global risk premium shocks and interpret mechanisms linking to commodity prices and trade openness.

### Characterizing the global dollar cycle and its correlates
- Established factors explain about one-fifth of US dollar fluctuations.
- The unexplained residual (global dollar cycle) accounts for the bulk of US dollar fluctuations over the last two decades; its correlation with the US dollar index is 84 percent.
- Quarterly correlations (2000:Q1–22:Q4, depending on data availability):
  - UIP deviations index correlation with the global dollar cycle: 0.69*.
  - Global financial cycle correlation with the global dollar cycle: −0.53* (global financial cycle variable ends in 2019:Q2).
  - VIX correlation with the global dollar cycle: 0.04.
  - Global uncertainty index correlation with the global dollar cycle: 0.09.
  - “ * ” indicates significance at the 1 percent level.
- Explanatory variables used to capture established interest rate developments:
  1. policy rates, including shadow rates;
  2. differences between US policy rates and those of major advanced economies;
  3. an index for US financial conditions to capture longer-term interest rate developments;
  4. a common component of economic activity in the rest of the world;
  5. lagged change in the US dollar index.
- Robustness: role of the global dollar cycle broadly unchanged under alternative specifications, alternative monetary policy shock series, alternative horizons for interest rates, and addition of commodity market developments.

### Key empirical findings and magnitudes
- Output spillovers:
  - A 10 percent US dollar appreciation decreases output by 1.9 percent after one year for emerging markets; the negative effect dissipates only after 10 quarters.
  - For smaller advanced economies, the negative effect peaks at 0.6 percent after one quarter and is considerably smaller and short-lived.
  - Using another statement: a US dollar appreciation by 10 percentage points is associated with a decline in real output by 1.9 percent in emerging markets 2 quarters after the initial appreciation and by 0.5 percent in advanced economies 2 quarters after the initial appreciation.
- Investment and trade:
  - Emerging markets experience an outsized decline in real investment driving differential output impact.
  - Trade volumes decline disproportionately more than economic activity for both groups; the magnitude of the decline in imports is roughly double the decline in exports.
- Current account and drivers:
  - Current account balances (share of GDP) increase in both groups following a US dollar appreciation.
  - For a 10 percent US dollar appreciation, peak increase is 1 percent of GDP, larger and more persistent for emerging markets.
  - A 10 percent appreciation increases the current account after five quarters by about 1 percent of GDP in emerging markets and by about 0.7 percent of GDP in advanced economies.
  - A depressed investment rate accompanying negative spillovers is the main contributor to the current account increase.
- Global effect:
  - A 10 percent US dollar appreciation is associated with a decline in global current account balances by 0.4 percent of GDP after one year.
  - Time-series local projections: a 10 percent appreciation is associated with a decrease in global balances of about 0.4 percentage points after one year.
  - Average global balances in examined period: 3.5 percent of GDP.
  - Standard deviation of global balances: 0.7 percent of GDP.
  - The negative effect on global balances is persistent and significant for up to four years, reversing thereafter.

### Exchange rate behavior and external adjustment channels
- Advanced economies:
  - REER depreciates persistently on impact after a US dollar appreciation, enabling expenditure switching.
  - Current account increase driven mainly by an increase in the services trade balance (boost to service exports as a share of GDP).
  - Monetary policy responses are systematically accommodative, mitigating negative spillovers; decline in domestic credit is shallow and short lived.
  - Public capital inflows increase, smoothing impact.
- Emerging markets:
  - REER does not respond on impact (consistent with “fear of floating”) and depreciates only gradually.
  - Income compression drives a large fall in imports in absence of prompt exchange rate adjustment; fall in imports observed across capital goods, intermediate consumption goods, and final consumption goods.
  - Policy rate responses show no systematic pattern and are even procyclical on impact; domestic credit declines persistently, extending beyond the 12-quarter horizon.
  - Stock prices decline by more in emerging markets than in advanced economies.
  - Net international investment position (NIIP) does not increase despite persistent current account surpluses, indicating systematic negative valuation effects.

### Financial transmission channels and amplification
- Capital flows:
  - Contemporaneous with US dollar appreciation, capital inflows to emerging markets (private and public) decline; private and public inflows normalized by lagged foreign liabilities.
  - Public capital inflows increase in advanced economies but not in emerging markets.
- Asset prices and credit:
  - Stock prices decline more in emerging markets.
  - Domestic credit contraction in emerging markets is persistent and amplifies spillovers.
- Overall: financial transmission channels magnify adverse spillovers in emerging markets relative to advanced economies.

### Heterogeneity by policy regimes and structural characteristics
- Sample-split features examined (thresholds and sources preserved as in chapter):
  - Exchange rate regime: coarse classification from Ilzetzki, Reinhart, and Rogoff (2019); Freely floating: 4; other regime: 1, 2, or 3.
  - Monetary policy credibility: country average of the measure in Bems and others (2021); threshold: Median.
  - US dollar liability exposure: share of foreign liabilities in US dollars from Bénétrix and others (2019); threshold: 75th percentile.
  - US dollar export invoicing: country average from Boz and others (2022); threshold: 75 percent of exports.
  - Trade openness: (Exports + Imports)/GDP from IMF Balance of Payments Statistics; threshold: Median.
  - Commodity exporter/importer: country median trade balance in all commodities from UN Comtrade; threshold: 5 percent of GDP.
- Monetary policy credibility:
  - More anchored inflation expectations mitigate negative spillovers by enabling accommodative policy responses.
  - For anchored emerging markets: REER depreciates, policy rate becomes more accommodative, investment remains stable, producing a shallower decline in output.
  - For less-anchored emerging markets: policy rates increase (marginal statistical significance); REER appreciates on impact, contributing to larger negative spillovers.
- Exchange rate flexibility:
  - Emerging markets with freely floating regimes exhibit systematically faster recoveries in output than those with less flexible regimes.
  - Less flexible regimes show larger increases in current account balances driven by both higher saving and lower investment.
  - Where flexible exchange rates are infeasible due to financial frictions, complementary tools—macroprudential measures and capital flow management measures—are recommended.

### Commodity exposure as a key driver of heterogeneity
- Core empirical findings:
  - Commodity exporters suffer larger negative spillovers due to pronounced deterioration in their terms of trade.
  - Commodity exporters’ terms of trade decrease by 10 percent after five quarters in response to a 10 percent US dollar appreciation.
  - Commodity exporters smooth temporary income drops by reducing saving and decreasing trade balances and do not show an increase in the current account.
  - Commodity exporters show no evidence of disproportionate REER depreciation or accommodative monetary policy.
  - Commodity importers experience improved terms of trade, shallower output declines, REER and monetary policy buffer impacts, and magnified current account increases; saving increases from the fifth quarter onward, improving NIIP gradually.
- Historical contrasts:
  - 2014–15: US dollar index appreciated by 16 percent; commodity prices fell by 32 percent. Real GDP forecast errors for 2015 show negative revisions for emerging market commodity exporters (trend line for 2015: y = –0.16x + 0.17; coefficient statistically significant at the 5 percent level, trend line excludes Brazil).
  - 2021–22: US dollar index appreciated by 10 percent; commodity prices increased by 34 percent. Real GDP forecast errors for 2022 show upward revisions for emerging market commodity exporters (exception: Russia); trend line for 2022: y = 0.05x + 0.54 (trend line excludes Russia).
  - Regression evidence cited: Obstfeld reports coefficient −2.45 (standard error of 0.42, R^2 = 0.15) for regression of oil-price change on dollar appreciation.
- Contextual note: The 2021–22 simultaneous commodity price surge and US dollar appreciation significantly muted or reversed negative spillovers for commodity-exporting countries in that episode.

### FSGM model simulations and mechanisms
- Model and shock:
  - Semistructural multiregion general equilibrium model: FSGM (Andrle and others 2015) using G20MOD module covering every G20 economy.
  - Primitive exogenous shock: UIP deviations operationalized as a global (excluding the United States) disturbance to sovereign spreads.
  - Main simulated shock: global persistent 1 percentage point shock to the sovereign premium.
- Key model features:
  - Interest rate reaction function: inflation-forecast-based rule under flexible exchange rate; higher weight on exchange rate deviations for emerging markets.
  - Long-term (10-year) interest rate based on expectations theory plus a term premium; interest rates on consumption, investment, government debt, and net foreign assets are weighted averages of 1- and 10-year rates.
  - Endogenous corporate risk premium dependent on the business cycle and commodity prices; sovereign risk premium affects all interest rates.
  - Commodity types: oil, food, metals; prices denominated in US dollar; calibration uses countries’ commodity production, consumption, and trade.
- Principal simulation results:
  - A global sovereign premium shock triggers a US dollar appreciation by increasing demand for US dollars as foreign risk-free returns decline.
  - Output declines worldwide, larger in emerging markets due mainly to more limited exchange rate flexibility.
  - Investment falls lead to large worldwide drop in imports because of high import propensity of investment goods, lowering global trade openness.
  - Commodity prices: simulation links a 1 percent US dollar appreciation to a 2.3 percent decline in commodity prices at a one-year horizon.
  - The US dollar pricing channel accounts for about 10 percent of the overall fall in commodity price after one year.
  - Current accounts and terms of trade: commodity importers benefit from commodity-induced terms-of-trade adjustment; commodity exporters experience offsetting forces in simulation leaving the current account broadly unchanged.
- Caveats:
  - FSGM omits balance sheet mismatches and a more nuanced modeling of central bank credibility; financial spillovers from advanced-economy sovereign shocks to emerging markets are modeled as exogenous rather than via intermediary channels.

### Policy implications and recommendations
- For emerging markets, policies to mitigate negative spillovers from US dollar appreciation:
  - Anchor inflation expectations to allow accommodative policy responses that facilitate real exchange rate depreciation and reductions in policy rates.
  - Adopt more flexible exchange rate regimes to speed recovery; support flexibility with domestic financial market development to deepen foreign exchange markets and expand hedging options.
  - Strengthen fiscal and monetary frameworks: ensure a well-balanced mix of fiscal and monetary policies, consolidate and enhance central bank independence, and improve transparency and effectiveness of communications.
  - Use precautionary policy tools, such as global safety nets and Integrated Policy Framework-linked tools, to address global financial market cycles and their spillovers.
  - In contexts of severe financial frictions and balance sheet vulnerabilities, deploy macroprudential and capital flow management measures to mitigate negative cross-border spillovers.
- Multilateral and research agenda:
  - Deeper understanding of UIP deviations is needed to inform multilateral policy options affecting the global dollar cycle.
  - Research avenues include spillovers from national and global regulation of financial intermediaries and sources of fluctuations in market-wide risk appetite and intermediary frictions.

*Source: CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE (PDF chapter).*

### Introduction

### ch2 - Introduction

### Context and research questions
- During the post–Bretton Woods era of flexible exchange rates, the US dollar has followed pronounced decade-long swings; the most recent sharp US dollar appreciation in 2021–22 is part of these oscillations.
- The chapter focuses on the external sector implications of the “global dollar cycle” for a sample of emerging markets and small advanced economies.
- The chapter addresses three questions:
  - Are there systematic external sector spillovers from the global dollar cycle?
  - Do effects differ across countries, and if so, what explains the heterogeneity?
  - What are the implications for global current account balances?

### Methodology
- Empirical approach: state-dependent local projections (LP) methodology, following Obstfeld and Zhou (2023).
- Simultaneous controls for established factors influencing US dollar fluctuations, including:
  - monetary policy developments,
  - broader US financial conditions,
  - economic activity trends in the rest of the world,
  - lagged change in the US dollar index.
- Residual component after controlling for established factors is labeled the “global dollar cycle.”
- Model-based simulations: analyze global risk premium shocks using the Flexible System of Global Models (FSGM; Andrle and others 2015) to interpret mechanisms and links to commodity prices and global trade openness.
- Structural heterogeneity: estimated impulse responses allowed to vary by country characteristics, with commodity exporter/importer status as a key exogenous structural feature.

### Key empirical findings and magnitudes
- Established factors together explain about one-fifth of US dollar fluctuations.
- The unexplained residual (global dollar cycle) accounts for the bulk of US dollar fluctuations over the last two decades; its correlation with the US dollar index is 84 percent.
- Negative output spillovers from a US dollar appreciation are concentrated in emerging markets:
  - A 10 percent US dollar appreciation decreases output by 1.9 percent after one year for emerging markets, and the negative effect dissipates only after 10 quarters.
  - In contrast, the negative effect in smaller advanced economies peaks at 0.6 percent after one quarter and is considerably smaller and short-lived.
- Current account responses:
  - Current account balances, as a share of GDP, increase in both country groups following a US dollar appreciation.
  - For a 10 percent US dollar appreciation, the peak increase is 1 percent of GDP, larger and more persistent for emerging markets.
  - A depressed investment rate accompanying the negative spillovers is the main contributor to the current account increase.
  - Exchange rate depreciation and accommodative monetary policy facilitate external sector adjustment for advanced economies; “fear of floating” and less accommodation limit exchange rate adjustment in emerging markets, where income compression dominates.
- Commodity exposure as a driver of heterogeneity:
  - Commodity exporters exhibit larger negative spillovers owing to a pronounced deterioration in their terms of trade, reflecting a strong negative link between commodity prices and the US dollar (most commodities are invoiced in dollars).
  - Commodity importers experience the opposite: sizable current account surpluses, while commodity exporters face broad balance or even deficits.
- Policy effects:
  - Monetary policy credibility enables more accommodative responses to a US dollar appreciation (including reduced policy rates and REER depreciations), producing a shallower initial negative spillover.
  - A more flexible exchange rate regime systematically speeds up economic recovery and moderates current account increases.
- Global current account balances:
  - A 10 percent US dollar appreciation is associated with a decline in global current account balances by 0.4 percent of GDP after one year.

### Characterizing the global dollar cycle
- The US dollar trade-weighted index against currencies of major advanced economies exhibits pronounced decade-long swings; the 2021–22 appreciation is the most recent strong-dollar episode.
- The chapter focuses on a nominal US dollar trade-weighted index against currencies of major advanced economies to better capture exchange rate spillovers to emerging markets.
- Explanatory variables used to capture established interest rate developments:
  1. policy rates, including shadow rates;
  2. differences between US policy rates and those of major advanced economies;
  3. an index for US financial conditions to capture longer-term interest rate developments;
  4. a common component of economic activity in the rest of the world;
  5. lagged change in the US dollar index.
- Robustness: extensive robustness tests show the estimated role of the global dollar cycle is broadly unchanged under a wide variety of alternative specifications, including alternative monetary policy shock series, alternative horizons for interest rates, and addition of commodity market developments.

### Interpretation and limitations
- The global dollar cycle is estimated as a residual and potentially contains many endogenous factors not further disentangled in the chapter.
- The chapter shows—using model simulations—that global financial market shocks (distinct from interest rate differentials) could contribute to the global dollar cycle, but it does not preclude other interpretations that would require further advances in analyzing drivers of US dollar fluctuations.
- The analysis refrains from directly including commodity prices or terms of trade as explanatory variables because the global dollar cycle (as proxied by risk premium shocks) can be an important driver of commodity prices; FSGM simulations confirm this channel.

*Italic: IMF staff chapter authors: Cian Allen, Rudolfs Bems (lead), Lukas Boer, Allan Dizioli, and Racha Moussa, under the guidance of Jaewoo Lee. Research support: Abreshmi Nowar and Xiaohan Shao; editorial assistance: Jane Haizel.*

### CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE

### CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE

### Financial-market linkages and identification
- The chapter links financial market forces to a residual not explained by established exchange rate determinants, using identification by exclusion to address unobservable underlying financial shocks.
- Financial markets can be both transmission channels for conventional macro shocks and sources of financial shocks (example: a decrease in investor risk appetite leading to appreciation of a safe-haven currency such as the US dollar).
- The chapter focuses on measures correlated with the global dollar cycle to interpret underlying shocks, with emphasis on UIP deviations and the global financial cycle.

### Correlates of the global dollar cycle
- An index of UIP deviations is strongly positively correlated with the global dollar cycle: 0.69*.
- The global financial cycle is strongly negatively correlated with the global dollar cycle: −0.53*.
- Chicago Board Options Exchange Volatility Index (VIX) correlation with the global dollar cycle: 0.04.
- Global uncertainty index correlation with the global dollar cycle: 0.09.
- Note: Quarterly correlations over 2000:Q1–22:Q4 depending on data availability (global financial cycle variable ends in 2019:Q2). “ * ” indicates the correlation is significant at the 1 percent level.

### Interpretation of UIP deviations and mechanisms
- UIP deviations, λit, are decomposed as λit = iit − itUS − (ln(E(St+kLC/$)) − ln(StLC/$)), where variables are defined in the chapter.
- Two candidate mechanisms for the strong UIP–global-dollar-cycle correlation:
  - Risk premium channel: fall in risk appetite induces US dollar appreciation as a safe asset, with expected subsequent dollar depreciation creating UIP deviation correlation.
  - Intermediary compensation channel: higher demand for US dollars leads financial intermediaries to demand a higher expected return for supplying dollars.
- The chapter uses both simulated risk premium shocks in a general equilibrium model and constructed UIP deviations as alternative sources of global financial shocks to study spillovers to emerging markets.

### Empirical framework for spillover analysis
- Uses local projections (LP) following Jordà (2005) and Obstfeld and Zhou (2023).
- Main regressor: first difference of a trade-weighted US dollar index against currencies of major advanced economies.
- Excludes from sample countries with a weight in the index greater than 4 percent.
- Sample composition: 15 advanced and 19 emerging market economies (retains advanced economies with a weight in the US dollar index that are less than 4 percent in 2020 to boost sample size).
- Controls: US policy rates and their differences with those of other advanced economies, US financial conditions, an economic activity factor for spillover countries, lagged country-specific controls (GDP growth, policy rate, bilateral exchange rate against the US dollar), lags of global controls, change in the US dollar index, and lags of dependent variable.
- Allows for state-dependent LP (Ramey and Zubairy 2018) to estimate differential responses by policy and structural characteristics.

### Differential spillovers: advanced economies vs emerging markets
- A US dollar appreciation by 10 percentage points is associated with:
  - A decline in real output by 1.9 percent in emerging markets 2 quarters after the initial appreciation.
  - A decline in real output by 0.5 percent in advanced economies 2 quarters after the initial appreciation.
- Recovery profiles:
  - Advanced-economy output recovers after 3 quarters.
  - Emerging-market output remains depressed 10 quarters out.
- Real investment:
  - Emerging markets experience an outsized decline in real investment driving the differential impact on output.
- Trade volumes:
  - Trade volumes decline disproportionately more than economic activity for both country groups.
  - The magnitude of the decline in imports is roughly double the decline in exports.
- Current account (share of GDP):
  - A 10 percent appreciation in the US dollar increases the current account after five quarters by about 1 percent of GDP in emerging markets.
  - The same shock increases the current account after five quarters by about 0.7 percent of GDP in advanced economies.
- Saving and investment contributions:
  - Decline in investment drives current account increases around one year out in both country groups.
  - Investment is the main driver of the divergent longer-term current account response, recovering strongly in advanced economies but remaining depressed in emerging markets.
  - Saving does not show a clear systematic response across groups, except a contemporaneous significant but short-lived drop in emerging markets.

### Exchange rate behavior and external adjustment channels
- Advanced economies:
  - The REER depreciates persistently on impact following a US dollar appreciation, enabling expenditure switching and contribution to external sector adjustment.
  - Current account increase is driven mainly by an increase in the services trade balance (boost to service exports as a share of GDP).
- Emerging markets:
  - The REER does not respond on impact (consistent with “fear of floating”) and depreciates only gradually over subsequent quarters.
  - In the absence of prompt exchange rate adjustment, income compression drives a large fall in imports, which contributes to the current account increase.
  - The fall in imports of goods is observed across capital goods, intermediate consumption goods, and final consumption goods.
- US dollar invoicing in trade is more prevalent in emerging markets, further hindering expenditure switching.

### Financial transmission channels and amplification in emerging markets
- Capital flows:
  - Contemporaneous with US dollar appreciation, capital inflows to emerging markets (private and public) decline.
  - Private and public inflows are normalized by lagged foreign liabilities.
- Net international investment position (NIIP):
  - Emerging markets: NIIP does not increase despite persistent current account surpluses, indicating systematic negative valuation effects.
  - Advanced economies: NIIP increases, driven by both current account surpluses and an initial positive valuation effect stemming from the US dollar appreciation.
- Public capital inflows:
  - Increase in advanced economies, smoothing the impact of the global dollar cycle; this channel does not operate in emerging markets.
- Monetary policy and domestic financial conditions:
  - Advanced economies: US dollar appreciations are systematically associated with accommodative monetary policy, mitigating negative spillovers; decline in domestic credit is shallow and short lived.
  - Emerging markets: Policy rate responses show no systematic pattern and are even procyclical on impact; domestic credit declines persistently, extending beyond the 12-quarter horizon.
  - Using short-term interest rates instead of policy rates yields similar findings.
- Asset prices:
  - Stock prices decline by more in emerging markets than in advanced economies.
- Overall: financial transmission channels magnify adverse spillovers in emerging markets relative to advanced economies.

*Source: CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE (PDF chapter).*

### 1. Private Inflows

### 1. Private Inflows

### The Role of Policy Regimes and Structural Characteristics
- Objective: Analyze why emerging markets experience larger negative spillovers than advanced economies by estimating state-dependent responses to a 10 percent appreciation in the nominal US dollar index (impulse responses shown with 90 percent confidence intervals).
- Method: Sample split into subgroups by policy and structural characteristics; state-dependent impulse responses estimated mirroring whole-sample procedure.
- Key examined features (as categorized in Table 2.2):
  - Exchange rate regime: coarse classification from Ilzetzki, Reinhart, and Rogoff (2019); Freely floating: 4; other regime: 1, 2, or 3.
  - Monetary policy credibility: country average of the measure in Bems and others (2021); threshold: Median.
  - US dollar liability exposure: share of foreign liabilities in US dollars from Bénétrix and others (2019); threshold: 75th percentile.
  - US dollar export invoicing: country average from Boz and others (2022); threshold: 75 percent of exports.
  - Trade openness: (Exports + Imports)/GDP from IMF Balance of Payments Statistics; threshold: Median.
  - Commodity exporter/importer: country median trade balance in all commodities from UN Comtrade; threshold: 5 percent of GDP.
- Identification challenges highlighted:
  - Many characteristics highly correlated with the advanced/emerging market split (notably US dollar liability exposure and monetary policy anchoring).
  - Characteristics are often collinear with each other (example: exchange rate regime correlated with US dollar export invoicing).
  - To mitigate endogeneity and collinearity, commodity exporter/importer status is used as a key exogenous structural feature; other characteristics’ contributions are estimated controlling for commodity status. Where overlap is severe, estimation is limited to the emerging market sample.

### Monetary Policy Credibility and Spillovers
- Finding: Monetary policy anchoring mitigates negative spillovers from US dollar appreciations by enabling accommodative policy responses.
- Evidence (emerging markets sample only; impulse responses to 10 percent US dollar appreciation with 90 percent confidence intervals):
  - Emerging markets with more anchored inflation expectations exhibit a shallower initial decline in output; the difference is statistically significant.
  - When inflation expectations are anchored:
    - The REER depreciates.
    - The policy rate becomes more accommodative.
    - Investment remains stable, contributing to a shallower decline in output.
  - For less-anchored emerging markets:
    - Policy rates increase (marginal statistical significance).
    - The REER appreciates on impact rather than depreciating, contributing to larger negative spillovers.
- Note: Controlling for commodity-exporting or -importing status does not change the findings regarding monetary policy credibility.

### Commodity Exporters versus Importers
- Core result: Commodity exporters suffer larger negative spillovers from a US dollar appreciation due to concurrent deterioration in their terms of trade.
- Quantitative responses (full sample; impulse responses to 10 percent US dollar appreciation with 90 percent confidence intervals):
  - Terms of trade for commodity exporters decrease by 10 percent after five quarters.
  - Commodity exporters:
    - Smooth temporary income drops by reducing saving and decreasing trade balances.
    - Do not show an increase in the current account in response to the US dollar appreciation.
    - Show no evidence of disproportionate REER depreciation to offset falling commodity prices (consistent with "fear of floating").
    - Show no evidence of accommodative monetary policy.
  - Commodity importers:
    - Terms of trade improve, which partially offsets negative spillovers.
    - Decline in output is shallower.
    - REER and monetary policy further buffer the impact.
    - Current account increase is magnified; saving increases from the fifth quarter onward, improving the NIIP gradually.
- Contextual note: The 2021–22 strong US dollar episode coincided with a commodity price surge (due to pandemic recovery and supply disruptions from Russia’s war in Ukraine), which significantly muted or reversed negative spillovers for commodity-exporting countries in that episode.

### Exchange Rate Flexibility and Complementary Policies
- Finding: After accounting for commodity trade, exchange rate flexibility significantly affects output spillovers.
  - Emerging markets with freely floating exchange rate regimes exhibit systematically faster recoveries in output than those with less flexible regimes.
  - Less flexible regimes show larger increases in current account balances driven by both higher saving and lower investment.
- Policy implication:
  - Flexible exchange rates provide shock-absorbing properties.
  - For emerging markets with severe financial frictions and balance sheet vulnerabilities, flexible regimes may not be immediately feasible.
  - Such countries should use complementary tools—macroprudential measures and capital flow management measures—to mitigate negative cross-border spillovers under limited exchange rate flexibility.

### Implications for Global Balances
- Time-series local projections estimate the impact of US dollar appreciations on global balances (impulse responses show a 10 percent appreciation in the nominal US dollar index with 68 and 90 percent confidence intervals).
- Quantitative estimates:
  - A 10 percent appreciation of the US dollar is associated with a decrease in global balances of about 0.4 percentage points after one year.
  - Average global balances in the examined period: 3.5 percent of GDP.
  - Standard deviation of global balances: 0.7 percent of GDP.
  - The negative effect on global balances is persistent and significant for up to four years, reversing thereafter.
- Mechanisms:
  - Falling commodity prices reduce chronic current account surpluses of commodity exporters and deficits of importers, compressing global balances.
  - Dominant currency pricing and reduced trade flows (Gopinath and others 2020) may amplify the effect.
  - US dollar appreciation can tighten collateral constraints for importers that borrow in US dollars (Casas, Meleshchuk, and Timmer 2022).

### Model Simulations: FSGM
- Purpose: Use a semistructural multiregion general equilibrium model to examine a candidate structural shock (a change in global risk premiums) that may drive the empirically estimated spillovers.
- Model: FSGM (Andrle and others 2015), using the G20MOD module covering every G20 economy.
- Relevant model features:
  - Monetary authorities and interest rates:
    - Interest rate reaction function: inflation-forecast-based rule under a flexible exchange rate.
    - Higher weight on exchange rate deviations for emerging markets (consistent with fear of floating).
    - Long-term (10-year) interest rate based on expectations theory of the term structure plus a term premium.
    - Interest rates on consumption, investment, government debt, and net foreign assets are weighted averages of the 1- and 10-year interest rates, allowing a meaningful role for the term premium.

*Source: IMF staff calculations.*

### CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE

CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE

### Model structure and key mechanisms
- UIP deviations in the model are represented as risk premiums. Different borrowers (households, firms, government) face varying interest rates depending on time horizons and risk profiles. The UIP condition holds in the short term only for the sovereign if the sovereign risk premium is zero; the calibrated model has a nonzero exogenous sovereign risk premium and a term premium on long-term bonds.
- The model contains an endogenous corporate risk premium that depends on the business cycle and on commodity prices. The sovereign risk premium affects all interest rates; the corporate risk premium affects only private-sector rates.
- Commodity exposure: the FSGM incorporates three commodity types—oil, food, and metals—with prices denominated in the US dollar. Calibration uses countries’ commodity production, consumption, and trade.
- External sector: exports and imports are determined by foreign and domestic activity and the exchange rate, with producer pricing. Investment, household saving, and fiscal policy determine the current account and implied net-foreign-asset positions.

### Simulation setup
- The primitive exogenous shock analyzed is UIP deviations operationalized as a global (excluding the United States) disturbance to sovereign spreads.
- Main simulated shock: a global persistent 1 percentage point shock to the sovereign premium.
- Regional aggregation for results: advanced economies (excluding the United States), emerging markets, and within emerging markets—commodity exporters and commodity importers.

### Principal simulation results and quantitative links
- Exchange rate and capital flows:
  - A global sovereign premium shock triggers a US dollar appreciation by increasing demand for US dollars as foreign risk-free returns decline (short-term interest rates do not immediately change while the risk premium rises).
- Output and trade:
  - The shock raises financing costs, reducing domestic consumption and investment via intertemporal substitution and cost-of-capital channels, producing a fall in output in the rest of the world.
  - Output declines are larger in emerging markets, attributed mainly to more limited exchange rate flexibility.
  - Investment falls lead to a large worldwide drop in imports because of high import propensity of investment goods, lowering global trade openness.
- Commodity prices:
  - The model generates a strong negative link between the US dollar and commodity prices through the demand channel: as global demand declines, commodity demand and real commodity prices fall.
  - Quantified relationship in the simulation: a 1 percent appreciation in the US dollar is associated with a 2.3 percent decline in commodity prices at a one-year horizon.
  - The US dollar pricing channel accounts for about 10 percent of the overall fall in the commodity price after one year.
- Current accounts and terms of trade:
  - Commodity importers benefit from the commodity-induced terms-of-trade adjustment: lower import values temporarily increase real income and savings (income effect); a substitution effect from a lower consumption-based real interest rate partly offsets this. In the calibration, these effects broadly offset and weak investment primarily drives the current account increase.
  - For commodity exporters, two opposing forces offset: higher cost of capital and lower investment raise the current account, while falling commodity prices reduce export values and lower saving, decreasing the current account. In the simulation the responses broadly offset, leaving the current account unchanged.
  - Aggregate result: the current account increases only in commodity-importing countries, more so in emerging market commodity importers because of the larger fall in investment.

### Historical episodes and event-study contrasts
- Historical comovement: correlation between the US dollar index and commodity prices for the sample period is −0.38.
- 2014–15 episode:
  - US dollar index appreciated by 16 percent; commodity prices fell by 32 percent.
  - Real GDP forecast errors for 2015 show systematic negative revisions for emerging market commodity exporters, especially those with larger commodity trade surpluses (trend line for 2015: y = –0.16x + 0.17; coefficient statistically significant at the 5 percent level, trend line excludes Brazil).
- 2021–22 episode:
  - US dollar index appreciated by 10 percent; commodity prices increased by 34 percent.
  - Real GDP forecast errors for 2022 show systematic upward revisions for emerging market commodity exporters (exception: Russia) and small downward revisions for advanced commodity exporters (trend line for 2022: y = 0.05x + 0.54; trend line excludes Russia).
  - The unusual simultaneous strengthening of commodity prices and the US dollar in 2021–22 mitigated negative spillovers to vulnerable emerging market commodity exporters; instead, negative spillovers fell disproportionately on emerging market commodity importers.
- Regression evidence cited: Obstfeld reports coefficient −2.45 (standard error of 0.42, R^2 = 0.15) for a regression of oil-price change on dollar appreciation.

### Caveats and model omissions
- The FSGM omits potentially important factors that could amplify spillovers:
  - Balance sheet mismatches and a more nuanced modeling of central bank credibility are not captured and could magnify negative spillovers.
  - Financial spillovers from advanced-economy sovereign shocks to emerging markets are modeled as exogenous shocks to financial conditions rather than via explicitly modeled intermediary channels.

### Policy implications and recommendations
- For emerging markets, policies that mitigate negative spillovers from US dollar appreciation include:
  - Anchoring inflation expectations to allow accommodative policy responses that facilitate real exchange rate depreciation and reductions in policy rates.
  - Adopting more flexible exchange rate regimes to speed recovery; flexibility should be supported by domestic financial market development to deepen foreign exchange markets and expand hedging options.
  - Strengthening fiscal and monetary frameworks: ensuring a well-balanced mix of fiscal and monetary policies, consolidating and enhancing central bank independence, and improving transparency and effectiveness of communications.
  - Using precautionary policy tools, such as global safety nets and Integrated Policy Framework-linked tools, to address global financial market cycles and their spillovers.
  - In contexts of severe financial frictions and balance sheet vulnerabilities, deploy macroprudential and capital flow management measures to mitigate negative cross-border spillovers.
- Multilateral and research agenda:
  - A deeper understanding of UIP deviations is needed to inform multilateral policy options affecting the global dollar cycle.
  - Research avenues include understanding spillovers from national and global regulation of financial intermediaries and examining sources of fluctuations in market-wide risk appetite and intermediary frictions.

*Source: IMF staff calculations and chapter text from CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE*

### Box 2.1 (continued)

### Box 2.1 (continued)

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*Source: CHAPTER 2 EXTERNAL SECTOR IMPLICATIONS OF ThE GLObAL DOLLAR CyCLE, Box 2.1 (continued).*

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_Source: https://www.imf.org/-/media/files/publications/esr/2023/english/ch2.pdf_