How does a strong dollar affect emerging economies?

By Pablo Druck

What is the effect of a stronger or weaker US dollar on emerging markets’ economic activity? Frenkel (1986) documents that US monetary easing – usually related to a more depreciated dollar – results in higher commodity prices, and vice versa. Dornbusch (1986), Borensztein and Reinhart (1994), and Akram (2009) show that nominal and real commodity prices depend negatively on the US real exchange rate. In parallel, Engel and Hamilton (1990) have long ago documented the long swings in dollar values. However, we are not aware of any systematic evidence of the link between the strength of the US dollar and economic activity in emerging markets over the dollar cycle – less so of any study documenting the transmission channel. In a recent paper (Druck et al., 2015) we try to bridge this gap.

Using data for 1970–2014, we document that:

• During periods of US dollar appreciation, real GDP growth in emerging markets slows despite the positive impulse of US growth, and vice versa.

The main transmission channel is through an income effect owing to the impact of the dollar on global commodity prices. As the dollar appreciates, dollar commodity prices tend to fall. In turn, weaker commodity prices depress domestic demand via lower real (dollar) income. Thus, real GDP in emerging markets decelerates. Moreover, we show that these effects hold despite any potential expenditure-switching effect resulting from the relative currency depreciation of emerging market economies when the dollar appreciates. We also show that despite controlling for the effects of the US real exchange rate appreciation and real GDP growth, an increase in the US interest rate further reduces growth in emerging markets. All these effects are stronger in countries with more rigid exchange rate regimes. Finally, although net commodity exporters are affected the most, countries that rely on importing capital or inputs for domestic production will also be affected. Therefore, at the time of writing, emerging markets’ growth is likely to remain subdued reflecting, in part, the expected persistence of the strong dollar and the anticipated increase in the US interest rates.

Why the US real effective exchange rate has such an impact? For developing countries, this is essentially an exogenous variable. Most international transactions are priced in US dollars, including commodity prices. And emerging markets (excluding perhaps China) cannot affect much the weights in the multilateral exchange rate of the US. Thus, developments in the US affect emerging markets – and not vice versa. Further, the independence of US macroeconomic policy with respect to less developed countries suggests that the US real exchange rate is likely to be more relevant and even more exogenous than the terms of trade.

Historical context: Some stylised facts

• Stronger US dollar, lower emerging markets’ growth.

Periods of US dollar appreciation coincide with softer real GDP growth rates throughout emerging market regions (Figure 1) – and vice versa. This stylised fact is especially strong for regions that are strong net commodity exporters.

Figure 1. US dollar strength and real GDP growth in emerging markets

Sources: IMF, World Economic Outlook; and IMF, International Financial Statistics; and IMF staff calculations.
Note: REER = Real Effective Exchange Rate. Increase = depreciation.

• Stronger U.S. dollar, softer real domestic demand growth.

Figure 2 presents a similar picture as Figure 1, but using the growth rate of real domestic demand. It suggests that domestic demand is a strong driver of economic activity, beyond other factors that might influence domestic demand.

Figure 2. US dollar strength and real domestic demand growth in emerging markets

Sources: IMF, World Economic Outlook; and IMF, International Financial Statistics; and IMF staff calculations.
Note: REER = Real Effective Exchange Rate. Increase = depreciation.

• Higher US interest rates, a stronger US dollar.

Higher interest rates in the US tend to occur alongside a stronger dollar, and vice versa (Figure 3). Higher interest rates in the US increase capital inflows to the US searching for higher yields, appreciating the currency. Often, higher interest rates are also associated with stronger growth, though not always.

Figure 3. US dollar strength, real GDP growth, and real interest rates

Sources: IMF, World Economic Outlook; and IMF, International Financial Statistics; and IMF staff calculations.
Note: REER = Real Effective Exchange Rate. Increase = depreciation.

• Though not systematically, higher US interest rates appear to be associated with stronger US growth; Interest rate-economic activity relationship: stronger growth eventually generates demand-induced inflationary pressures.

Lack of sufficient (or fast enough) supply response translates into higher prices. The latter triggers the Fed into tightening its monetary policy, increasing borrowing costs and thus mitigating inflationary pressures through slower economic activity growth.

Dollar appreciation/depreciation cycles

Estimating a simple Markov-switching model with appreciation/depreciation regimes for the period 1970–2014, we find that real depreciations have been, on average, stronger and lasted longer than real appreciations. The real annual average appreciation is 3.2% per year with an average duration of over 6 years; the real average annual depreciation is 3.8% with an average duration of close to 9 years.1 In addition, these regimes are very persistent. A period of real appreciation is 83% more likely to remain appreciating in the following period than to switch regimes. For real depreciation, the probability of continuation of the state of nature is about 88%.2 Thus, we identify the following cycles:

Table 1. Appreciation and depreciation cycles

Event analysis

Next, we add dynamics to the average depreciation and appreciation cycles, based on event analysis using the dollar cycles identified above.3 Figure 4 shows the indices for the average real GDP during appreciation and depreciation episodes; Figure 5 shows real domestic demand.

Figure 4. Real GDP during US dollar appreciation and depreciation cycles

Source: authors’ calculation.

Except for Central America and Mexico, every other emerging region shows that real GDP is lower during periods of US dollar appreciation. We observe that this pattern holds for Latin America as an aggregate, and especially for South America. The latter is a strong commodity exporter – unlike Central America and Mexico. It also holds for emerging countries in the Middle East and North Africa Region (MENA), as well as for emerging Europe. To a lesser extent, it also true for emerging Asia. On average, Latin America’s slower growth results in real GDP being about 25 percentage points lower toward the end of the cycle during appreciation cycles than during depreciation cycles. South America’s differences are of similar order of magnitude. They are even higher in MENA countries – about 50 percentage points, while lower in emerging Asia, though still sizeable (at about 20 percentage points). There is not such a marked difference in Central America and Mexico, however. Among the possible causes of the latter, are the strong links via trade, tourism, and remittances. The trade link operates through the external demand for goods. Tourism boosts external demand for services. And remittances transfer resources from the US to Mexico, Central America, and the Caribbean. All these factors help increase domestic demand and income in the emerging and developing countries. Thus, they could offset any negative income effect owing to the stronger dollar. Countries with hard pegs or outright dollarization tend to be further synchronised with the US’ business cycle.

Figure 5. Real domestic demand during US dollar appreciation and depreciation cycles

Source: authors’ calculation.

• Regarding domestic demand, except for Central America and Mexico, all other regions and sub-regions experience much stronger real domestic demand growth when the US dollar is more depreciated.

In fact, in many of the regions domestic demand actually decreases or remains flat during appreciation phases. We take this as a powerful indication of the negative impact of a stronger dollar on the purchasing power of domestic demand. In turn, this could suggest that it might be the case that the income effect actually dominates the (expenditure-switching) substitution effect in some cases.

Some simple econometrics

After sketching a simple model to rationalise our findings, we run two sets of simple regressions to test the above stylised facts. The left-hand side variable is either the growth rate of emerging markets’ real GDP or real domestic demand, respectively. Despite controlling for US and China’s real GDP growth rates (external demand), US real interest rates (financial channel), net capital inflows (availability of external financing), volatility (uncertainty), commodity terms of trade, and several other controls, there is a strong statistically significant effect of the US real effective exchange rate on emerging markets’ growth. This effect is negative, particularly so for domestic demand. It holds across different emerging regions, with varying degrees. It is especially strong for net commodity exporters. But it is also relevant for countries that rely on importing capital or inputs to produce. For economies with more exchange rate flexibility, the effect is weaker on output, but stronger on domestic demand, as expected. Thus, a stronger US dollar lowers real GDP and domestic demand growth.

Table 2. Real GDP growth rate and demand growth rate

Going forward

The US dollar is on an appreciating cycle since mid-2014. Based on our historical estimations, the probability of the dollar remaining appreciated in the short- and medium-term is high (above 80%), in line with appreciating cycles in the US dollar of about 6­8 years. In the circumstances, commodity prices would remain weak. Together, these effects point to slower domestic demand and real GDP growth in emerging markets than otherwise – across all regions.

Moreover, in the context of a lift-off in US interest rates as the Federal Reserve is expected to start unwinding the extraordinary expansionary monetary policy implemented in recent years, if anything, the US dollar is more likely to remain strong. Capital inflows to emerging markets are likely to moderate at best (even if no capital flow reversal takes place), on the back of weaker commodity prices. Unfortunately, thus, the external front for these economies is not promising.

Strong US growth is good for emerging markets, as external demand for the latter increases. Beyond that effect, however, a stronger US dollar mitigates the expansionary effect of faster growth in the US, via an income effect. The latter, in turn, is particularly strong for commodity exporters and countries with more rigid exchange rate regimes. To a lesser extent, countries that rely on importing capital and intermediate inputs in production could also experience this offsetting income effect via domestic demand. And higher US real interest rate further adds to the mitigation/amplification effect or the tighter/easier financial conditions that usually come along with a more appreciated dollar.

Disclaimer: The views expressed are those of the authors and do not necessarily represent the views of the IMF, its Executive Board of management.

References

Akram, Q F (2009), “Commodity Prices, Interest Rates, and the Dollar”, Energy Economics, Vol. 31, pp. 838–851.

Borensztein, E and C Reinhart (1994), “The Macroeconomic Determinants of Commodity Prices”, IMF Staff Papers, Vol. 41, No. 2 (June), pp. 236–261.

Dornbusch, R (1986), “Inflation, Exchange Rates and Stabilization,” Essays in International Finance, No. 165, (October), pp. 1-24. International Finance Section, Princeton, NJ: Princeton University Press.

Druck, P, N Magud, and R Mariscal-Paredes (2015), “Collateral Damage: Dollar Strength and Emerging Markets’ Growth”, International Monetary Fund Working Paper 15/179, July (Washington: International Monetary Fund).

Engel, C and J Hamilton (1990), “Long Swings in the Dollar: Are they in the Data and Do Markets Know it?”, The American Economic Review, September, pp. 689-713.

Frenkel, J (1986), “Expectations and Commodity Price Dynamics: the Overshooting Model”, Journal of Agricultural Economics, Vol. 68, No. 2 (May), pp. 344-348.

Footnotes

1 Excluding the current (ongoing) appreciation cycle we find that appreciation cycles are still shorter than depreciation cycles, but less so. The average length is about 8 years. The average annual appreciation rate is 3.4%, and the average annual depreciation rate is 3.7%.

2 The results from excluding the current appreciation cycle imply a slightly higher persistence of depreciation cycles (92%), and similar expected persistence for appreciation cycles (82%).

3 Given that each event is not necessarily of the same period length, we discretize the length of each event. To this end, let us call period t0 the first observation in any appreciation or depreciation cycle and (the real GDP) observation in the last year of the appreciation or depreciation cycle as t4. Let us standardise real GDP in period t-1 equal to 100. Given the data for real GDP growth rates for each (PPP-weighted) real GDP, we reconstruct the indexed real GDP for each region. We discretize the time-space to compute the real GDP index at the half-life of each event, as well as at quarter-life and three-quarter-life. Last, we compute basic statistics across each set of appreciation and depreciation episodes at t0, ¼, ½, and ¾ and t, respectively (which we label as t0, t1, t2, t3, and t4, respectively).

This article is published in collaboration with Vox EU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Pablo Druck is a Senior Economist, International Monetary Fund. Nicolas Magud is a Senior Economist at the International Monetary Fund. Rodrigo Mariscal is a Research analyst in the Western Hemisphere Department, IMF.

Image: A portrait of Benjamin Franklin on a U.S. One-hundred dollar bill is pictured at Interbank Inc. money exchange in Tokyo. REUTERS/Yuriko Nakao 

Source: https://agenda.weforum.org/2015/08/how-does-a-strong-dollar-affect-emerging-economies/

The false equality between commodity-money and Fiat System

By Daniele Pace*

In dealing with this topic we must first do a premise of clarification on the current conception of the Fiat System by those who hold power: the banking system.

Despite the Fiat System is based on a trust structure by the nominal value, the banking system continues to think this kind of money, in relation to inflation, as if it was a commodity money of medieval style, based on the intrinsic value, thus fuelling among economists, the belief that the currency might inflate itself depending on its quantity. The intrinsic value of gold from centuries past is now replaced by the trust, according to the governor Draghi^[1], and it hold up the value of money. In this specific the problem is still different from what is discussed in the previous chapter.^[2]

Until recently, you could read on the website of the Bank of Italy as in the past the erosion of the precious metal in the coins in order to profit affected inflation, decreasing the value of each individual issue. Today this misinterpretation of inflation due to the erosion of the metal is less and less "publicized", as to be gone from the websites of many official banks.

This example of the erosion of the metal in relation to inflation, very popular before the crisis, certainly tended to the confusion between the value of one currency and the index of consumer prices, and to justify the existence of a central body predisposed to a strong control on inflation as the Deutsche Bundesbank style.

In fact, in historical reconstructions reported in several texts, including my The Utopian Money, is revealed as the currency in the past it had been issued in its value in two separate criteria, the one that had a nominal value, and another that had an intrinsic value.

The first currency was the Aristotelian numisma, in which the value was determined by law and made many times more that intrinsic, so that was not the metal to determine it, but the law of the state.

The second currency was instead the commodity-money largely used when the concept of numisma was forgotten and the value of the coins was determined by the weight of the metal. These were the first currencies of the Eastern concept, used in the West until the various reforms based on the Aristotelian concept of the measure of value, adopted in Rome for a long time and abandoned with the fall of the Empire. In this regard, much has been said about the responsibility that had the emperors in decreasing the metal content of their money, but in reality, being these of value established by law, the reduction in the quantity of the metal had no impact on the coinage, and as well on inflation that has no ties to the money supply. The real monetary problem of the late empire was the monetary crunch and not the reduction of the metal content.

Economists today have not yet been able to give a definition of money but only to determine the characteristics. Definitions however are very different from each other depending on the economic current of reference, although the introduction of the Euro would have to provide valid information to define the real nature of money. Economists instead seem stuck on concepts that do not consider the social and legal aspects that modern money brings, aspects very well detailed instead by Professor Auriti at the University of Teramo.

The introduction of the Euro, by means of a law, in no way encouraged the academics of the Faculty of Economics, closed in their economic principles influenced by Anglo-Saxon literature that by its nature can not, in the case of the economy, to include social concepts and legal in these studies.

So the understanding of modern money, that currency which economists would able to inflate with increasing the money supply, remained at concepts conceived during the regimes of Gold Standard and commodity money, thus excluding the conventional currency established by law, the same law that, with a stroke of the pen, has seen the birth of the Euro. The jurisprudence has established, but in this case it is more appropriate to say “imposed”, the Convention-Euro currency.

The question is: may a convention inflate itself?

What is the difference between numisma-money in antiquity, the gold of the following centuries, and today's currency Fiat trust, and what its relationship with inflation?

We can say that the numisma-money and the modern Fiat money are created by law, without any relation to the material that depicts the symbol, while the commodity-money gold had a behaviour absolutely equal to any goods with fluctuating value.

While in the numisma-money the metal was only the media to represent the value, as is the paper and the digital number of the computer in the modern Fiat money, in that golden the metal was the intrinsic value of the coin. So this can only be regarded as a commodity, while the other two currencies are laid down in the value of the law that creates a convention. The legal agreement can not be subject to inflation and the fundamental error of the economists, past and current, was to define money as a commodity, as well as today continues to discuss the banking system. This is in the case of inflation than in the loan interest.

But as now revealed with the introduction of the Fiat system, and how exposed two millennia ago by Aristotle, the currency can not be a commodity, but only a convention to be set by law, the Aristotelian nomos completed in thought by Giacinto Auriti.^[3]

Here then is the fundamental error in the approach to money is still perpetrated in using primarily economic models designed during the Gold Standard, now superseded by a new monetary model, and secondly by treating money as if it was a commodity and not a social convention whose value and the creation of which are established by law.

Money can not be a commodity even if there are similarities of form. As to the substance, but particularly his creation, there are mechanisms and processes not only different, but also belong to fields which have nothing to do with each other.

The similarities of form are in the possibility of exchange, in the measurement of a value and use-value, but the creation of the goods and the money come in and follow processes, one material, the other spiritual, which between they are not associated.

The commodity is an economic good, natural or processed, exchangeable for other goods, which has need of an economic business-cycle related to a time and a real working production and use value.

Even natural goods need time and resources. The wood for example needs the growth of the tree and the assimilation of nutrients, that is labour and natural energy. The oil needs of chemical processes and times geologically large. Any material good produced by man needs a production cycle equally to the natural cycles of the earth.

The modern money on the contrary, is yes exchangeable for goods and has a use-value being a medium of exchange, but it does not need of economic business-cycles that employ time and work because it is time, spirit and Convention, that is jurisprudence. It has no value as a primary human need and not as an expression of human work, but as an expression of social convention, which does not require "labour" but legal rule. Money can not be a commodity as it lacks to capture the specific use-value that characterise a good. It has a purchasing power, which is its use-value, the expected timing of its use as a medium of exchange and measure of the value in the exchange. But it is convention as it is not the material element to confer it, but the social convention, the agreement between the parties, now imposed by law, that it has that value. To exist today, as it was in the times of numisma, only it needs the social convention, sets, or consensual. Paper and ink, then spirit and law. The material that represents the value does not matter, and therefore the economic business-cycle from which is made, when there is a convention, as such as today the money is created for 90 percent, by computerized records intangible.

It is therefore a social creation of value over time, stable and shared, which has an instrumental function, created by the human spirit, the creative mind, thus made simply the law. There is not an economic business-cycle, there is not material or work.

The difference with the goods in the process of money creation is evident. This despite having a utilitarian use in the exchange, it has not the consumption / enjoyment "classic" proper of goods. A social convention imposed or consensual, created by the mind and / or the law can not inflate itself in any way, and its value is determined arbitrarily and not according to the alleged "natural laws".

In fact its behaviour in the circulation is completely different from any other commodity.^[4]

The modern economy would like a relationship between money supply and inflation, apparently as in the case of an erosion of the metal, not coincidentally making reference time ago on the website of the Bank of Italy. Today this reference has disappeared but it remains a kind of track when you try to tie the modern conventional currency to inflation.

A note or a digital writing however, can not diminish their value as this is conventionally written. They can certainly buy less goods than in the past, but as a result of higher prices and not to the reduction of their value, which remains fixed.

This fixed value will be highlighted in the continuation of this work with the dissertation on the Fisher equation in which you would like to demonstrate a relationship between inflation and money supply^[5]. For now it is sufficient to break the causal and direct link between the increase in the money supply and inflation that the equation would like to demonstrate and that the agreement imposed by the state already denies it being invariable.

The money in fact in the past it was accepted as customary, defined then as legal induced value by Professor Auriti^[3], that the state converts in Convention through law. Once granted that a single banknote, and today a digital number, has a determined value X, this can not be modified because the sum of the banknotes, or of digital numbers, varies. This will necessarily be the sum of the values of X, which remain constant as the value of a banknote, which remains a legal certificate for all purposes, not variable, as well as the digital number of computer with which it dispenses bank credit, that is the promise to request monetary liquidity in the same species from the bank.

Extract from: The Fruiterer Conspiracy

*Daniele Pace - Writer and independent researcher - Author of The Fruiterer Conspiracy and The Utopian Money

[1] Archive of the Bank of Italy, The culture of monetary stability Unit today. Speech by Mario Draghi, April 4, 2001 (http://www.bancaditalia.it/interventi/integov/2011/draghi-040411/Inaugurazione_Mostra_04_04_2001.pdf )

[2] Price inflation and currency devaluation, pag. 14

[3] The utopian country, Giacinto Auriti, free PDF, (http://www.signoraggio.com/auriti/ilpaesedellutopia_auriti.pdf)

[4] Pre-existence of V and T in the exchange: Store of Value and circulation, pag. 61

[5] PART THREE, pag. 39

The Fruiterer Conspiracy - Money and inflation (book)

By Daniele Pace *

 In my new book, "The Fruiterer Conspiracy - Money and inflation", I face, with a fresh approach, the issue of the price in relation to the increase in the money supply.

One of the reasons why it does not want to leave to governments the ability to manage monetary policy is inflation, where excesses of currency would cause irreparable damage.

In reality, not only this cause of inflation has never been proven, but they were very strong the debates among economists who saw this theory as totally wrong.

Today, the sovereign debt crisis is proposing again the "clash" between those who support the validity of this theory and those who consider it entirely fallacious.

The book covers a brief history of the Quantitative Theory of Money, which led to this authentic dogma of the modern economy, its inconsistencies and its opponents, to develop a new thinking, a new approach to the problem, and get to innovative conclusions for those Economists who have never given validity to the theory, repudiated also by the statistics and logic.

This brings us to the theorem of the pre-existence of values of factors in the Fisher equation, decreeing in that way the inapplicability to the determination of a link between the money supply and inflation. And this is where the innovative and never advanced so far approach in the analysis of the Quantitative Theory of Money. Not only a relationship of identity as advanced by those who denounced the inconsistencies, but a logical theorem that part of the three absurd, key hypothesis, which would affirm the Fisher equation, to get to the thesis and prove the pre-existence of values and so their inclusion as constants in the equation.

Assuming in fact valid the interpretation of those economists who want the increase the money supply due to inflation, while considering other factors, we would have three absurd logic that is dictated by the facts and experience:

1. The central bank and the banking system would decide and would communicate the prices of goods and services.

2. The prices are self-adjusted without the knowledge of producers / retailers.

3. There would be the "Fruiterer Conspiracy", where manufacturers and traders, experts in monetary matters, without the knowledge of consumers, conspire to divide between them the money supply.

It is quite clear that neither of these absurd could be true, and that therefore the Fisher equation does not hold logically when you try to use it to justify the price increase. And since "logic and mathematics form the core of rational science and go together combining their fields", it is the logic to suggest to establish a relationship between the factors of the equation and the Field of behaviour in which they are determined.

We not know entrepreneur / retailer who sets their prices according to the money supply, nor as well it exist a paranormal phenomena in which prices must adapt themselves to it. The assumptions lead to the thesis that the logic states the pre-existence of factor P (and other factors) to be included as a constant in the equation as this is decided in advance by economic entities and not by the money supply, only variable. In fact, both governments and central banks, in their economic programs, use statistical data measured on the territory supplied by the National Institutes prepared for the calculation of inflation.

The conclusion is that the Fisher equation no longer has any validity both to demonstrate a relationship with inflation that in the calculation of the money supply, given the endogenous nature of the modern banking money. States are free to issue money as central banks lose the reason for their independence as the quantity of money is not determined in inflation.

To buy the book see the bottom af this article or the right site of the blog.

 * Daniele Pace is an independent researcher and writer on the monetary theme. In November 2012 he published his first book, "The Utopian Money", and in 2014 "Dialogues with Auriti". He is a speaker at numerous conferences on the subject and collaborator of columns, active for the dissemination and teaching of the Popular ownership of money and its Induced value.

Index

PART ONE

Introduction to inflation

Introduction

What is inflation

The three "causes" of inflation

Price inflation and currency devaluation

Myths of inflation: the false equality between commodity-money and Fiat System

PART TWO

The birth of the dogma

The birth of the dogma: the Quantitative Theory of Money

The economic business-cycle and inflation

PART THREE

The fruiterer conspiracy and the pre-existence of values

The starting absurd: the logic and the price

An interesting article by Philip Pilkington

Field of Behaviour and price

Pre-existence of P in the Field of Behaviour

The Field of Behaviour and other factors

Pre-existence of P: the empirical investigation and the constant in the equation

Pre-existence of V and T in the exchange: Store of Value and circulation

Conclusion

PART FOUR

The statistical data