BY ELISE GREEN
Elise Green is a second-year IDEV student pursuing a Master of Arts in International Economics. She interned with the Economics Research Department of the South African Reserve Bank, the central bank of South Africa.
The strengthening of the US dollar relative to currencies in emerging markets and developing market economies (EMDEs) is likely to exacerbate the economic consequences of COVID-19. Yet, additional research is needed to understand the precise impacts and to coordinate appropriate policies that would soften the economic and financial fallout in EMDEs.
The dominance of the US dollar proves detrimental in the midst of a pandemic
Literature about the dominant currency paradigm (DCP) is essential to understanding the state of global economics today. The DCP, as discussed by the International Monetary Fund (IMF), describes the effects of dominant currencies being used in pricing and financing of global trade. The notion of a dominant dollar extends beyond trade and finance – for example, the US enjoys an “exorbitant privilege” (a term coined by former French President and Finance Minister Valéry Giscard d’Estaing) due to the dollar as a global reserve currency and the fact that seigniorage allows the US to avoid balance of payments crises. This article, though, focuses on the DCP as a currency denomination issue. Recent literature and an updated dataset published by the IMF and European Central Bank (ECB) highlight the following key points about dominant currencies:
1) The US dollar plays a dominant role in the pricing of traded items. Bilateral trade between countries other than the US is often priced in the US dollar. This is particularly true for EMDEs, where almost 80% of manufacturing exports are invoiced in the US dollar, and also relevant for some advanced economies such as Australia, Japan, and Korea (Figure 1). The euro is also a widely used currency for trade invoicing, but mostly for trade that involves European countries and some countries in Africa.[1]
Figure 1. The US Dollar plays a dominant role in pricing for manufacturing trade[2]
2) Depreciation of a country’s currency relative to the US dollar is associated with a muted negative response of exports and a significant contraction of imports when traded items are invoiced in US dollars and prices are assumed to be sticky. In the medium term, prices are less sticky and flexible exchange rates can play a conventional buffering role against the exchange rate (making exports competitive and providing external rebalancing) (Figure 2).[3]
Figure 2. Importers are significantly hurt by a local currency depreciation
(response of trade quantities to a 10% depreciation vis-à-vis all currencies, percent of GDP[4])
3) Foreign currency debt in non-financial firms has risen rapidly in the past two decades, especially in emerging markets. Foreign currency debt in emerging markets rose from about 25% of total credit to nearly 40% of total credit (about 4500 million USD) from 2008 to 2019 (Figure 3). Emerging market economies tend to have greater exposure to foreign currency financing than advanced economies.[5]
Figure 3. Total foreign currency borrowing is increasing
(data for the non-financial corporate sector; million USD on left, percent of total credit on right[6])
The impacts of pricing in a dominant currency, notably the US dollar, deviate slightly from the exchange rate impacts implied by conventional economics. The economic theory we are taught in school assumes that a weaker domestic currency will raise the price of imports and boost export competitiveness, thus increasing domestic demand and reviving struggling economies. However, the empirical data suggest that currency depreciations relative to dominant currencies, like the US dollar, will not help the short-term recovery of economies, especially EMDEs, impacted by the COVID-19 pandemic. When a country prices its goods and services in the US dollar, importers are significantly negatively affected by the local currency depreciating against the US dollar in the short term (when prices are assumed to be sticky) because demand for imports will fall as imports lose competitiveness against domestically produced items. True, a currency appreciation relative to the US dollar would have an expansionary effect on imports; however, the US dollar tends to appreciate in times of crises,[7] and EMDE currencies sharply depreciated as COVID-19 rattled markets in March this year. Additionally, dominant currency pricing entails muted responses of exports because the export price is little changed—the domestic items priced in a dominant currency do not change in competitiveness for foreign buyers in the short term. The limited reaction of exports to a local currency depreciation thus severely inhibits economic recovery from an exchange rate shock.
Financing in a dominant currency also has implications on a firm’s balance sheet, depending on how traded items are priced. Exporting firms using dominant currency pricing and financing have a “natural hedge”: They are somewhat protected from exchange rate risk because liabilities and revenues move together when affected by currency fluctuations. However, firms pricing their imports in the producing country’s currency but borrowing in a dominant currency will see unmatched movements between revenues and liabilities—leading to negative impacts on the balance sheet, constrained financing, and overall less demand for imports—when faced with a currency depreciation relative to the dominant currency. Overall, dominant currency pricing and financing weaken the external rebalancing mechanisms and shock-buffering role of flexible exchange rates.
The dominance of the US dollar and its strengthening relative to the currencies of EMDEs imply that the dominant currency paradigm has contractionary effects on trade and the global economy. Since COVID-19 emerged in March 2020, the US dollar has strengthened by nearly 25% against the Brazilian real, more than 10% against the Mexican peso and Russian ruble, and about 8% against the South African rand.[8] The macroeconomic shocks of COVID-19 are thus expected to burden EMDEs the most. This is especially true as sectors that are less commonly priced in dominant currencies, such as tourism, are inhibited by lockdown and travel restrictions and thus face other non-currency issues due to the pandemic.
Lingering questions
Literature and data related to the dominant currency paradigm are important for understanding the state of global economics, but gaps in research and a lack of clear remedial policies persist. Three key questions come to mind:
1) How are firms’ profits impacted by dominant currency pricing?
I outlined the macroeconomic response of import and export quantities to a currency depreciation relative to the US dollar, but the potential positive microeconomic impacts of dominant currency pricing need further investigation. At the micro level, exporters with revenues in a dominant currency and costs in the producing country’s currency would likely achieve higher revenue relative to costs—and thus higher earnings overall—when faced with a local currency depreciation. Likewise, importers using dominant currency pricing for revenues may see their revenues per unit increase relative to cost per unit; however, the overall profitability of the firm would depend on whether the increase in revenues offsets the simultaneous contraction of import quantities and total costs. Analyzing the impacts of dominant currency pricing on revenues, in addition to trade volumes, would provide insight into the impact of dominant currency pricing on firm profitability.
2) How fast do prices adjust, given an exchange rate shock?
The IMF and ECB authors modeled the effects of trade volumes and exchange rate pass-through during the same year as the shock (short term) and three years later (medium term). The assumptions were chosen because prices are assumed to be sticky in the short term and flexible in the medium term, but it is unclear how fast prices respond to changes in demand given a change in the exchange rate. Evidence of price elasticity relative to an exchange rate depreciation may be useful for determining the impact of exchange rate depreciation on trade volumes at various points in time, not just at the one- and three-year marks.
3) What are the implications of the insights we have so far?
The policy implications of the dominant currency research are somewhat unclear. Gita Gopinath, Chief Economist of the IMF, has noted that “in the absence of other frictions, flexible exchange rates are still optimal”[9] and that the dominance of the US dollar is unlikely to cease in the near future (although this could be disputed with the rise of digital and crypto currencies).[10] Thus, encouraging countries to revert to fixed exchange rate regimes would be unwise. Elaboration on the short-term “supportive policies” suggested by the IMF is also warranted. For example, when and to what extent should emerging markets with prevalent dominant currency invoicing and financing focus on using unconventional policy tools, such as macroprudential policy, exchange rate interventions, and capital flow controls (highlighted in the IMF’s “Integrated Policy Framework”[11])? And how can a country maximize the coordination of these policy tools and address policy spillovers in global markets? As the historical features of the dominant currency paradigm are unlikely to change in the near future, governments and banking institutions would benefit from a framework with clear suggested practices.
In sum, recent IMF and ECB research and data about the dominant currency paradigm are compelling and logical: The near-term external rebalancing mechanism of floating exchange rates is severely weakened under dominant currency pricing and financing. Flexible exchange rates may, in turn, have negative repercussions on the global economy, especially given supply chain disruptions and demand shocks from COVID-19. Additional research should address the microeconomic impacts, such as firm profitability, and price elasticity of a currency depreciation relative to the US dollar. Moreover, supportive policies should be outlined to soften the blow of COVID-19 to EMDEs. For now, governments and central banks in EMDEs should understand that the dominant currency paradigm is yet another barrier to economic recovery in a post-pandemic world.
[1] Gustavo Adler et al., 2020, “Dominant Currencies and External Adjustment,” IMF staff discussion note no. 20/5, p.8. Available here.
[2] Adler, Gopinath, and Buitron, 2020, “Dominant Currencies and the Limits of Exchange Rate Flexibility,” IMF Blog. Available here.
[3] Adler et al. 2020, p. 13.
[4] Adler, Gopinath, and Buitron 2020.
[5] Adler et al. 2020, p. 20.
[6] Ibid.
[7] Gourinchas, Rey, and Govillot, 2017, “Exorbitant Privilege and Exorbitant Duty,” Institute for Monetary and Economic Studies, Bank of Japan. Available here.
[8] Giles and Szalay, 2020, “Global Economy Unlikely to Benefit from Falling Dollar,” Financial Times. Available here.
[9] Adrian and Gopinath, 2020, “Toward an Integrated Policy Framework for Open Economies,” IMF Blog. Available here.
[10] Gopinath 2020, “Digital currencies will not displace the dollar,” Financial Times. Available here.
[11] Basu et al. 2020, “A Conceptual Model for the Integrated Policy Framework,” IMF Working Paper WP/20/121. Available here.
PHOTO CREDIT: Free use image from Canva Pro.