Decreasing exports, combined with supply and demand disruptions are expected to weaken the local currencies of emerging markets and developing economies (EMDEs) in the short term, said an International Monetary Fund (IMF) report released on Tuesday.
Amid the ongoing COVID-19 crisis, EMDEs have faced an unprecedented shock of collapsing global demand and commodity prices, capital outflows, major supply chain disruptions and a generalised drop in global trade, which drove their currencies to witness a sharp weakeness, according to the IMF.
Building on its dataset, the IMF demonstrated that the short-term gains from weaker currencies may be limited in 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.
In this regard, the IMF’s analysis found that the share of US dollar trade invoicing across EMDEs far exceeds their share of trade with the US, given their growing role in the global economy, increasingly relevant for the international monetary system.
“Exporting firms that use the US dollar or euros for both pricing and financing are naturally hedged as liabilities and revenues move in tandem when exchange rates fluctuate. This means foreign currency financing is less of a concern when concentrated in exporting firms. Revenues and liabilities of importing firms, however, are typically not matched, and exchange rate fluctuations bring about balance sheet effects that constrain financing and import volumes. Dominant currency financing tends to amplify the effect of a country’s depreciation on its Imports,”, read the IMF report.
The prevalent use of the US dollar in corporate financing reflects how it has globally contractionary effects through importing firms' balance sheets, according to the IMF’s analysis.
Additionally, the global strengthening of the US dollar is likely to increase in the short-term fall in global trade and economic activity, as 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 United States, according to the analysis.
The report showed that exchange rates still have a role to play to contain capital outflow pressures and support the recovery over the medium term, yet sustaining the domestic economy in the short term requires a decisive use of other policies, such as fiscal and monetary stimuli, including through unconventional tools.
Key sectors that would normally respond more to exchange rates, like tourism, are therefore likely to be hampered by COVID-19 containment measures and consumer behaviour changes.