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, a research work jointly undertaken by three staff members of the International Monetary Fund (IMF), Gustavo Adler, Gita Gopinath and Carolina Osorio Buitron, has said.
The research work was titled : “Currencies and Crisis: How Dominant Currencies Limit the Impact of Exchange Rate Flexibility”
The research noted that 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 dollar—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 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 US. 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,” it said.
Another important implication of the use of the US dollar in trade pricing is that a global strengthening of the US dollar entails short-term contractionary effects on trade.
This is because the weakening of other countries’ currencies vis-à-vis the US dollar leads to higher domestic currency prices of their imports, including from countries other than the US, and, thus, a lower demand for them.