IMF Working Papers

This paper studies how dominant-currency pricing affects currency risk premia. Empirically, we
extract common risk factors from excess currency returns using principal components and relate countries’
factor exposures to observable macroeconomic characteristics, with export dollar invoicing emerging as a
predictor of carry trade exposure. A small open-economy model with dominant-currency pricing and
dollar-denominated liabilities explains why. Dollar export invoicing weakens the exchange rate's stabilizing
effect on external demand, while dollar debt makes depreciation costly for leveraged intermediaries. When the
two frictions interact, depreciations occur in bad states, local-currency assets become risky, the currency
premium rises, and the risk-adjusted neutral rate increases. Under a standard Taylor rule, this mechanism
generates persistently higher inflation.