As we all know, the US dollar has long played a humungous role in global markets. It continues to do so, even as the American economy has been producing a shrinking share of global output over the last two decades.
The US share in world merchandise exports has declined from 12 percent to 8 percent since 2000, the dollar’s share in world exports has held around 40 percent. For many countries fighting to bring down inflation, the weakening of their currencies relative PRIOR to the dollar has made the fight harder. On average, the estimated pass-through of a 10 percent dollar appreciation into inflation is 1 percent. Such pressures are especially acute in emerging markets, reflecting their higher import dependency and greater share of dollar-invoiced imports compared with advanced economies. The dollar is at its highest level since 2000, having appreciated 22 percent against the yen, 13 percent against the Euro and 6 percent against emerging market currencies since the start of this year.
As the chart illustrates, readings for a growing share of G20 countries have fallen from expansionary territory earlier this year to levels that signal contraction. That is true for both advanced and emerging market economies, underscoring the slowdown’s global nature. October PMI releases point to weakness in the fourth quarter, particularly in Europe. In China, intermittent pandemic lockdowns and the struggling real estate sector are contributing to a slowdown that can be seen not only in PMI data but also in investment, industrial production, and retail sales. This will inevitably have a significant impact on other economies due to China’s large role in trade.
Despite growing evidence of a global slowdown, policymakers should continue to prioritize containing inflation, which is contributing to a cost-of-living crisis, hurting low-income and vulnerable groups the most. As our G20 report emphasizes, the macroeconomic policy environment is unusually uncertain.
Global economic growth prospects are confronting a unique mix of headwinds, including from Russia’s invasion of Ukraine, interest rate increases to contain inflation, and lingering pandemic effects such as China’s lockdowns and disruptions in supply chains.In turn, our latest World Economic Outlook, released last month, lowered our global growth forecast for next year to 2.7 percent, and we expect countries accounting for more than one third of global output to contract during part of this year or next.
By contrast, the currencies of smaller economies that haven’t traditionally figured prominently in reserve portfolios, such as the Australian and Canadian dollars, Swedish krona and South Korean won, account for three quarters of the shift from dollars.
Two factors may help to explain the movement into this set of currencies:
- These currencies combine higher returns with relatively lower volatility. This appeals increasingly to central bank reserve managers as foreign exchange stockpiles grow, raising the stakes for portfolio allocation.
- New financial technologies—such as automatic market-making and automated liquidity management systems—make it cheaper and easier to trade the currencies of smaller economies.
The challenges that the global economy is facing are immense and weakening economic indicators point to further challenges ahead. However, with careful policy action and joint multilateral efforts, the world can move toward stronger and more inclusive growth. A regression analysis of global reserve currency shares confirms that a higher economic risk premium, measured by the cost of using credit derivatives to insure against default, reduces a currency’s share in global reserves. Evidently, holders favor the currencies of countries known for good governance, economic stability and sound finances. For the United States, despite the global fallout from a strong dollar and tighter global financial conditions, monetary tightening remains the appropriate policy while US inflation remains so far above target. Not doing so would damage central bank credibility, de-anchor inflation expectations, and necessitate even more tightening later—and greater spillovers to the rest of the world.
BY: SHANNUL H MAWLONG
https://www.imf.org/en/Blogs/Articles/2022/10/14/how-countries-should-respond-to-the-strong-dollar
