IMF warns central banks against taking this one step as they fight strong US dollar

The International Monetary Fund (IMF) on Friday put out a detailed note suggesting ways the countries can respond to a strong US dollar, which has weakened other currencies significantly, including the rupee. The Indian rupee has fallen over 8% since January this year and is currently trading at over 82 per dollar. 

Currently, the dollar is at its highest level since 2000, having appreciated 22% against the yen, 13% against the Euro, and 6% against emerging market currencies since the start of this year. The spike in the dollar began after America’s central bank – Federal Reserve – started raising the interest rate in order to fight super hot inflation in the US. 

In a blog post, IMF’s Gita Gopinath and Pierre-Olivier Gourinchas said that a sharp strengthening of the dollar in a matter of months has sizable macroeconomic implications for almost all countries, given the dominance of the dollar in international trade and finance.

While the US share in world merchandise exports has declined from 12% to 8% since 2000, the post said, the dollar’s share in world exports has held around 40%. For many countries fighting to bring down inflation, they said, the weakening of their currencies relative to the dollar has made the fight harder. 

They noted that approximately half of all cross-border loans and international debt securities are denominated in US dollars and as world interest rates rise, the financial conditions have tightened considerably for many countries.

In these circumstances, the paper said, several countries are resorting to foreign exchange interventions. Total foreign reserves held by emerging markets and developing economies fell by more than 6% in the first seven months of this year.

The IMF said that the appropriate policy response to depreciation pressures requires a focus on the drivers of the exchange rate change and on signs of market disruptions. “Specifically, foreign exchange intervention should not substitute for warranted adjustment to macroeconomic policies,” the agency said, adding that there is a role for intervening on a temporary basis when currency movements substantially raise financial stability risks and disrupt the central bank’s ability to maintain price stability.

As of now, it said, economic fundamentals are a major factor in the appreciation of the dollar: rapidly rising US interest rates and a more favorable terms-of-trade — a measure of prices for a country’s exports relative to its imports — for America caused by the energy crisis. It further said that given the significant role of fundamental drivers, the appropriate response is to allow the exchange rate to adjust while using monetary policy to keep inflation close to its target. 

“The higher price of imported goods will help bring about the necessary adjustment to the fundamental shocks as it reduces imports, which in turn helps with reducing the buildup of external debt. Fiscal policy should be used to support the most vulnerable without jeopardizing inflation goals,” the paper underlined.

The IMF has advised the countries to use their foreign reserves prudently. It said emerging market central banks have stockpiled dollar reserves in recent years but these buffers are limited and should be used prudently. “Countries must preserve vital foreign reserves to deal with potentially worse outflows and turmoil in the future,” the paper warned.  

In the past few months, many countries have tried to arrest the decline in their currency by selling dollars. India’s central bank, too, has sold over 110 billion dollars in the last 13 months. India’s forex reserves have now plummeted to 532 billion dollars from the record high of 642.45 billion registered on September 3, 2021.     
 
Gopinath is the Deputy Managing Director of the IMF and Gourinchas is the Economic Counsellor and the Director of Research.