Emerging market economies are grappling with the impact of a stronger US dollar, according to the latest External Sector Report by the International Monetary Fund (IMF). The study highlights the disproportionate negative spillovers experienced by these economies compared to smaller advanced economies when the US dollar appreciates.
The report finds that a 10 percent appreciation of the US dollar, driven by global financial market forces, leads to a 1.9 percent decrease in economic output in emerging market economies after one year. This drag on growth persists for two and a half years. In contrast, the negative effects on advanced economies are smaller in scale, peaking at 0.6 percent after one quarter and subsiding within a year.
The adverse effects in emerging market economies stem from both trade and financial channels. These economies experience a sharper decline in real trade volumes, with imports dropping twice as much as exports. They also face challenges such as worsened credit availability, reduced capital inflows, tighter monetary policy, and significant stock market declines.
The impact on the current account, which reflects changes in saving-investment balances, is also notable. As a percentage of gross domestic product (GDP), current account balances increase in both emerging market economies and smaller advanced economies, primarily due to a decrease in investment rates. However, the effect is more pronounced and enduring for emerging market economies.
The report suggests that emerging market economies with anchored inflation expectations and flexible exchange rate regimes fare better in mitigating the adverse effects. Anchored inflation expectations provide more policy flexibility, enabling looser monetary policy after a depreciation and resulting in a shallower initial decline in real output. Moreover, economies with flexible exchange rate regimes experience a faster economic recovery due to immediate exchange rate depreciation.
To support flexible exchange rate regimes, it is crucial to develop domestic financial markets that reduce the sensitivity of borrowing conditions to exchange rate fluctuations. Additionally, sustained commitments to improving fiscal and monetary frameworks, central bank independence, and effective communication are vital for anchoring inflation expectations.
The study also emphasizes the global implications of a stronger US dollar. Global current account balances decline by 0.4 percent of world GDP after one year with a 10 percent appreciation of the US dollar. This contraction in trade, influenced by dominant currency pricing and falling commodity prices, signals potential financial vulnerabilities and trade tensions.
The IMF report underscores the need for precautionary policy measures such as global safety nets to address global financial market cycles and their spillover effects. In emerging market economies with significant financial frictions and balance sheet vulnerabilities, macroprudential and capital flow management measures could help mitigate negative cross-border spillovers.