London, July 26 (HNA) – The International Monetary Fund (IMF) published a new blog, on dominant currencies and exchange rate flexibility, written by Gustavo Adler, Gita Gopinath, and Carolina Osorio Buitronof the IMF; including the discussions by Gita Gopinath, Philip Lane from European Central Bank, Ana Fernanda Maiguashca from Colombia’s Banco de la República, and Hyun Shin from the Bank for International Settlements—moderated by Soumaya Keynes of The Economist.
Faced with an unprecedented shock of collapsing global demand and commodity prices, capital outflows, major supply chain disruptions and a generalized drop in global trade, many emerging markets and developing economies’ (EMDEs) currencies have weakened sharply. Will these currency movements support the recovery of these economies?
Building on a new dataset, research laid out in a new IMF Staff Discussion Note indicates that the short-term gains from weaker currencies may be limited. This is especially true for EMDEs where firms price their international sales and finance themselves in a few foreign currencies, notably the US dollars— so-called Dominant Currency Pricing and Dominant Currency Financing.
The central assumption underlying the traditional view on exchange rates is that firms set their prices in their home currencies. As a result, domestically-produced goods and services become cheaper for trading partners when the domestic currency weakens, leading to more demand from them and, thus, more exports. Similarly, when a country’s currency depreciates, imports become more expensive in-home currency terms, inducing consumers to import less in favor of domestically-produced goods. Thus, if prices are set in the exporter’s currency, a weaker currency can help the domestic economy recover from a negative shock.
However, there is growing evidence that most of the global trade is invoiced in a few currencies, most notably the —US dollar—a feature dubbed Dominant Currency Pricing or Dominant Currency Paradigm. In fact, the share of US dollar trade invoicing across countries far exceeds their share of trade with the United States. This is especially true in EMDEs and, given their growing role in the global economy, increasingly relevant for the international monetary system.
The inception of the euro initially reduced the dominance of the US dollar somewhat, but the latter has remained largely unabated since then. Other reserve currencies play a limited role. Dominant currency pricing is common both in goods and in services trade, although it is less prevalent in the latter—especially in some sectors, like tourism.
Our analysis of dominant currencies suggests that the weakening of EMDE’s currencies is unlikely to provide a material boost to their economies in the short term as the response of most exports will be muted, besides the physical disruptions to trade from supply and demand disruptions.
Meanwhile, key sectors that would normally respond more to exchange rates—like tourism—are likely to be impaired by COVID-related containment measures and consumer behavior changes. Additionally, the global strengthening of the US dollar—which mainly reflects a flight to safe-haven assets—is likely to amplify the short-term fall in global trade and economic activity, as both higher domestic prices of traded goods and services and negative balance sheet effects on importing firms, lead to lower import demand among countries other than the US.
Exchange rates still have a role to play to contain capital outflow pressures and support the recovery over the medium term, but sustaining the domestic economy in the short term requires a decisive use of other policy levers, such as fiscal and monetary stimuli, including through unconventional tools.