According to the IMF, for every 10% appreciation of the US dollar linked to global financial market forces, emerging market economies suffered a decline in Gross Domestic Product (GDP) output of 1.9% after one year, a drag that is expected to last for 2.5 years.
The same research showed that the impact was much smaller in advanced economies, with a peak output reduction of 0.6% after one quarter, and the effects largely disappeared after one year.
The IMF said in the report that the dollar’s real effective exchange rate climbed 8.3% in 2022 to its strongest level in two decades, amid a rapid series of interest rate hikes by the Federal Reserve to curb inflation and rising global commodity prices fueled by Russia’s invasion of Ukraine.
“Emerging market and developing economies with pre-existing vulnerabilities, such as high inflation and misaligned external positions, experienced increased depreciation pressures, while commodity-exporting economies benefited from rising commodity prices,” the IMF said.
Many emerging market economies suffered worsening credit availability, declining capital inflows, monetary policy tightening, and further stock market declines.
In advanced economies, more flexible exchange rates were able to absorb some of the shock through depreciation, while more easy monetary policy also helped, provided inflation expectations were firmly anchored, the IMF said.
“More anchored inflation expectations help by allowing greater latitude in the monetary policy response. Following a depreciation, a country can ease monetary policy if expectations are anchored. The result is a less pronounced initial decline in real output,” the report’s authors write in a blog post.
“In turn, emerging market economies with more flexible exchange rate regimes tend to enjoy faster economic recovery due to immediate significant exchange rate depreciation.”
The IMF recommended that emerging market countries move toward flexible exchange rates by developing domestic financial markets that reduce the sensitivity of loans to exchange rates, and committing to improving fiscal and monetary frameworks, including central bank independence, to help anchor inflation expectations.
The Foreign Sector Report showed that IMF staff estimated that the dollar was overvalued in 2022 by between 3.5% and 14.6%, with a midpoint of 9%. In April 2022, the IMF said the value of the dollar was 0.5% below its 2022 average.
The Fund also said the euro was overvalued in some currency bloc countries, by around 10% in Italy and Finland, while it was undervalued in others, by 8% in Germany.