A strong dollar is bad news for emerging market economies, according to the Bank for International Settlements.
BIS economists Boris Hofmann and Taejin Park evaluated the impact of changes in the nominal effective exchange rate on average growth outlooks for emerging market economies using data covering 21 countries between 1990 and 2020. They found that an increase of 1 percentage point in the value of the U.S. dollar can dampen the growth outlook by more than 0.3%.
The main drag on emerging markets from a strong dollar is tighter global financial conditions, the study showed.
A strengthened dollar can result in a general tightening of global dollar credit supply, including for trade credit as some borrowers see their liabilities rise relative to their assets and are left in weaker credit positions. The BIS economists noted that this effect could also play out in local currency government bond markets, resulting in tightening credit conditions.
"These negative effects are significantly larger in countries more exposed to changes in global credit conditions, because of high foreign investment in local currency bond markets or high dollar debt," Hofmann and Park wrote.
The report noted that the broad dollar exchange rate was a more important gauge of investor appetite for risk than closely followed barometers such as the CBOE volatility index, or VIX, which measures expected price swings in the S&P 500 index.
Flight to safety
"When investor risk appetite dives, flight to safety may both push up the dollar and weaken global economic activity through capital outflows and tighter financial conditions as investors and lenders retrench from risky investments and borrowers," Hofmann and Park wrote.
This relationship was exemplified during the COVID-19 pandemic.
"In the wake of the first wave of the pandemic, the U.S. dollar initially appreciated on a broad basis by almost 10% in the first three months of the year, accompanied by record bond portfolio outflows from [emerging market economies] and sharply widening EME bond spreads. Subsequently, when the pandemic situation eased in the summer, the dollar depreciated and bond portfolio flows and spreads normalized," Hofmann and Park wrote.
The report found that emerging markets also suffered through the negative impact of a strong dollar on trade.
While a strengthened dollar could improve the competitiveness of exports from countries that experience a bilateral depreciation in their own currency, often international trade is conducted in dollars, pushing up the prices for importers and reducing the trade flow. This is a particular problem for many export-dependent emerging market economies, weighing on their output.
The preeminence of the dollar in the global financial system leaves emerging countries particularly vulnerable to swings in the exchange rate.
"We find that the dollar affects EMEs more strongly than small advanced economies and that appreciations of other safe haven currencies do not have similar adverse effects on EME growth," the economists said.