How Countries Should Respond to the Strong Dollar

IMF Blog, October 14, 2022

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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.
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.
Major fundamental drivers:
- Rapidly rising US interest rates as the Federal Reserve fights a historic increase in inflation.
- A more favorable US terms-of-trade due to the energy crisis.
- The massive terms-of-trade shock triggered by Russia’s invasion of Ukraine, with the euro area particularly affected through reliance on energy imports, especially natural gas from Russia.
- Divergent monetary conditions: the European Central Bank signaling a shallower path for policy rates, and low inflation in Japan and China allowing their central banks to buck the global tightening trend.

Inflation pass-through and import dependence:
- 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 higher import dependency and greater share of dollar-invoiced imports compared with advanced economies.
Balance-sheet and financing pressures:
- Approximately half of all cross-border loans and international debt securities are denominated in US dollars.
- Emerging market private corporate sectors have high levels of dollar-denominated debt despite progress by some emerging market governments in issuing debt in their own currency.
- As world interest rates rise, financial conditions have tightened considerably for many countries; a stronger dollar compounds these pressures and raises debt-distress risks for some emerging market and many low-income countries.
Reserve and market pressures:
- Total foreign reserves held by emerging market and developing economies fell by more than 6 percent in the first seven months of this year.
- With financial markets tightening, some countries are seeing signs of market disruptions such as rising currency hedging premia and local currency financing premia.

Core principle:
- Focus on the drivers of exchange-rate changes and on signs of market disruptions; foreign exchange intervention should not substitute for warranted adjustment to macroeconomic policies.
Monetary and fiscal policy guidance:
- Given 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 fundamental shocks by reducing imports and helping reduce the buildup of external debt.
- Fiscal policy should be used to support the most vulnerable without jeopardizing inflation goals.
Role of foreign exchange intervention:
- 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.
- Temporary intervention may be appropriate when severe disruptions in shallow currency markets trigger large changes in hedging and financing premia, or when large depreciations increase corporate default risks due to mismatches, or when a large exchange rate depreciation could de-anchor inflation expectations and monetary policy alone cannot restore price stability.

Preserve and prudently use reserves to deal with potential future outflows and market turmoil.
Reinstating swap lines with advanced-economy central banks is recommended for countries that are able.
Countries with sound economic policies facing moderate vulnerabilities should proactively avail themselves of the IMF’s precautionary lines to meet future liquidity needs.
Countries with large foreign-currency debts should reduce foreign-exchange mismatches by using capital-flow management or macroprudential policies, and by conducting debt management operations to smooth repayment profiles.
The Fed and global dollar provision:
- The United States should maintain monetary tightening while US inflation remains so far above target to preserve central bank credibility, even though large spillovers are likely to spill back into the US economy.
- 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 complement dollar funding provided by the Fed’s standing Foreign and International Monetary Authorities Repo Facility.

The IMF will continue to work closely with members using its Integrated Policy Framework to craft appropriate macroeconomic policies.
Beyond precautionary financing facilities available for eligible countries, the IMF stands ready to extend lending resources to member countries experiencing balance of payments problems.

IMF Blog: How Countries Should Respond to the Strong Dollar — Gita Gopinath, Pierre-Olivier Gourinchas, October 14, 2022