The dollar drag

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SummaryEffects of US monetary policy spill over into EMEs because of the overarching dominance of the dollar in the international monetary system

The current global debate on monetary policy is centred on whether it should target financial stability in addition to the domestic business cycle. With relatively tight regulation of financial markets, where present concerns are more developmental than regulatory, the counterpart debate in EMEs centres is on reconciling two widely held economic policy formulations, namely the Mundell-Fleming's Impossible Trinity and the Taylor Rule. The problem has become all the more compelling in a rapidly globalising world where large, volatile capital flows lead to misaligned and volatile exchange rates that threaten macroeconomic stability. The recent currency crisis which constrained Brazil, Turkey, Indonesia and India into tightening policy rates amidst collapsing growth, makes the case for reconciling the Impossible Trinity with the Taylor Rule of monetary policy all the more compelling.

Ceteris paribus, if a country runs a current account deficit (CAD), its currency should depreciate against those of its trading partners. There are, however, two major circumstances, one emanating from the current account (the 'Dutch disease syndrome'), and the other from the capital account (‘southern cone syndrome’) under which this reasoning does not hold. The latter is more germane here because large and volatile capital inflows into EMEs have become a far more frequent phenomenon as a result of loosening of financial regulation, innovation, globalisation and monetary policy spillovers. Cross-border flows of capital to EMEs have increased manifold since the 70s following the oil price hikes and export-led growth strategies adopted by several East Asian economies. The first manifestation of this syndrome in developing economies was the wave of financial liberalisation which led to a debt-fuelled recycling of petrodollars by American banks in the ‘southern cone’ in Latin America.

While large capital inflows can sustain large CADs for some time, over the medium- to long-run, they tend to magnify external imbalances and lay the ground for external payments crises. There are also large capital flows into countries running account surpluses. Once the capital surge abates, and particularly in the event of a sudden stop, there is a likelihood of a sudden, rapid and accelerated correction in exchange rates, with the nominal exchange rate depreciating sharply, and the Real Effective Exchange Rate (REER) overshooting its neutral (long-term fundamental) rate. This can cause short-term macroeconomic instability, such as higher inflation, a loss in international confidence and credit downgrade that could compound the reversal in capital flows and even precipitate an external payments crisis.

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