How the rapid appreciation of the US currency is causing stress in developing countries and emerging markets | D+C
The US dollar is currently appreciating rapidly. Against the backdrop of the crises caused by the Covid-19 shutdowns and the Russian invasion of Ukraine, this trend is causing difficulties in many developing countries and emerging markets. Central banks in high-income countries pay little attention to the global implications of their decisions.
Exchange rates have recently become increasingly volatile. Faced with inflation, the Fed (Federal Reserve – the central bank of the United States) adopted a hawkish policy, raising interest rates several times. The fed funds rate was close to zero at the start of the year and is now between 3 and 3.25%. For several reasons, this effort to control rising prices increases the risks of recession not only in the United States and may indeed lead to a global slowdown.
The pandemic and the war have generally increased uncertainty. Investors have therefore become more risk averse. Moreover, higher interest rates make investments in the real economy, which are important engines of growth, more expensive. The reason for this is that these investments are normally financed at least in part by loans. High interest rates therefore generally reduce growth. This mechanism applies to all economies, including the United States.
The great irony is that central bank interest rates have very little impact on energy and food prices, which are currently the main drivers of inflation. However, higher rates make clean energy investments more expensive, which would reduce the relevance of fossil fuel imports and make economies more environmentally sustainable.
The Fed’s new stance has other impacts internationally. Higher interest rates in the United States are an incentive for international investors to seek the safe harbor offered by the dollar. As a result, the dollar exchange rate continues to rise against the currencies of most economies. At the same time, the strong dollar tends to hurt developing economies in particular in several ways:
- Many of them – and in particular the least developed countries – cannot borrow in their own currency. They must service loans denominated in dollars in dollars. The service consists of repaying the loan plus the interest rate. As the dollar appreciates, their loans therefore become more expensive measured in their national currencies. The sovereign debt burden, which is already a huge problem in many countries, is growing.
- To prevent their own currencies from depreciating, central banks in other countries must follow the Fed’s lead and raise interest rates. They are already quite high in many developing countries and emerging markets. While higher interest rates help stem capital flight to safer financial assets in the United States, they make investing in the real economy even less attractive.
- If a dollar-denominated loan needs to be refinanced, the new loan will not only carry a higher exchange rate, but also a higher interest rate.
The current situation is extremely difficult. On the one hand, the central banks of developing countries want to encourage the inflow of foreign investment. On the other hand, rising interest rates increase the cost of domestic borrowing and have a stifling effect on growth. In the longer term, weaker growth is also likely to undermine government revenue, further aggravating debt problems.
The appreciation of the dollar also has repercussions on trade, especially since the American currency dominates international transactions. Even companies that operate in non-dollarized economies use it to settle business. Commodities, in particular, are usually bought and sold in dollars everywhere, so countries that export commodities may actually benefit to some degree from the strength of the dollar.
Other countries, however, often see their exports increase as well. The reason is that the high dollar exchange rate makes their products relatively cheap in the eyes of foreign buyers. On the other hand, imports become more expensive in terms of national currencies. This applies both to consumer goods – including food, on which some countries depend – and to intermediate goods needed to produce other goods. As a result, domestic companies may be forced to reduce their investments and/or production.
It is very important that most developing economies are so-called “price takers”. The term means that they are unable to influence world market prices. As they depend on world trade, they are forced to sell their goods at the prices currently paid. All in all, while economies with strong export sectors can benefit from a strong dollar as it allows them to sell even more abroad, most economies suffer.
Exchange rate volatility is a problem in itself
The high volatility of an exchange rate is also a problem in itself. Rapid and unpredictable changes in the external value of a currency contribute to the general feeling of uncertainty. The fastest exchange rate this year was the Russian ruble (mainly due to the war), followed by the Turkish lira and the Brazilian real. Such volatility tends to be counterproductive for the real economy, as it causes sharp reversals in capital flows and undermines planning. The threshold above which exchange rate volatility begins to negatively affect the real economy is generally lower in small economies than in large ones.
Finally, excessive exchange rate volatility has implications for monetary policy. It can make monetary policy ineffective, especially when there are inconsistencies between the policies of central banks and those of ministers in charge of finance and the economy. Persistent central bank interventions to stabilize exchange rates can also entail high costs. This may be the case in terms of declining foreign exchange reserves and/or the central bank buying assets of questionable value.
The appreciation of the dollar is currently aggravating economic problems in many places. The new Fed policy means tougher times for most disadvantaged nations. To a lesser, but still important extent, this also applies to the European Central Bank (ECB), which is also, albeit more slowly, raising its rates.
Central banks in high-income countries are not used to considering the impacts on poorer regions of the world. People in developing countries and emerging markets are used to the model of established Western powers appealing to the global common good when it suits them, but pursuing narrowly understood national interests when they can.
Unfortunately, developing countries have few options to deal with the challenges of short-term exchange rate depreciation and volatility. It is best to address these challenges pre-emptively rather than reactively. Generally speaking, developing country governments should only engage in sustainable borrowing and always ensure that they have a strong flow of domestic revenue.
However, even in times of crisis, policymakers must do their best to find ways to encourage investment to spur economic growth while reducing fiscal pressures. The international community, in turn, must do more to accelerate debt restructuring, which will be crucial to put developing countries back on a more sustainable fiscal path (see Kathrin Berensmann on www.dandc.eu).
André de Mello and Souza is an economist at Ipea (Instituto de Pesquisa Econômica Aplicada), a federal think tank in Brazil.