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Emefiele Vindicated as IMF says Currency Devaluation Gains Limited

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Nigeria’s Central Bank Governor Godwin Emefiele will be vindicated by new research by the International Monetary Fund (IMF), which suggests that the prevalence of dominant currencies like the US dollar in firms’ pricing decisions alters how trade flows respond to exchange rates, limiting the effectiveness of currency devaluations, in emerging markets.

The CBN Governor has  resisted steeper devaluation of the local currency the Naira, amid a slump in oil prices.

Emefiele instead has embraced so called heterodox monetary policy to manage the crises.

Faced with an unprecedented shock of collapsing global demand and commodity prices, capital outflows, major supply chain disruptions and a generalized drop in global trade, many emerging markets and developing economies’ (EMDEs) currencies have weakened sharply.

These currency movements may however not support the recovery of these economies, the IMF said in a new research paper released Monday.

“New dataset, research laid out in a new IMF Staff Discussion Note indicates that the short-term gains from weaker currencies may be limited. This is especially true for EMDEs where firms price their international sales and finance themselves in a few foreign currencies, notably the US dollar—so-called Dominant Currency Pricing and Dominant Currency Financing,” the IMF said.

The central assumption underlying the traditional view on exchange rates is that firms set their prices in their home currencies.

As a result, domestically-produced goods and services become cheaper for trading partners when the domestic currency weakens, leading to more demand from them and, thus, more exports.

Similarly, when a country’s currency depreciates, imports become more expensive in home currency terms, inducing consumers to import less in favor of domestically-produced goods.

Thus, if prices are set in the exporter’s currency, a weaker currency can help the domestic economy recover from a negative shock.

However, the IMF research says there is growing evidence that most of global trade is invoiced in a few currencies, most notably the US dollar—a feature dubbed Dominant Currency Pricing or Dominant Currency Paradigm.

This is seen by the share of US dollar trade invoicing across countries far exceeding their share of trade with the US. This is especially true in EMDEs and, given their growing role in the global economy, increasingly relevant for the international monetary system.

“The prevalence of dominant currencies like the US dollar in firms’ pricing decisions alters how trade flows respond to exchange rates, especially in the short term. When export prices are set in US dollars or euros, a country’s depreciation does not make goods and services cheaper for foreign buyers, at least in the short term, creating little incentive to increase demand. Thus, in EMDEs, where dominant currency pricing is more common, the reaction of export quantities to the exchange rate is more muted and so is the short-term boost of a depreciation to the domestic economy,” the IMF said.

The IMF notes that another important implication of the use of the US dollar in trade pricing is that a global strengthening of the US dollar entails short-term contractionary effects on trade.

This is because the weakening of other countries’ currencies vis-à-vis the US dollar leads to higher domestic currency prices of their imports, including from countries other than the US, and, thus, a lower demand for them.

The prevalence of the US dollar is also a feature of corporate financing in EMDEs. This feature—Dominant Currency Financing—means that exchange rate fluctuations can also have effects through their impact on firms’ balance sheets, a phenomenon widely studied in the literature.

A depreciation that increases the value of a firm’s liabilities relative to its revenues weakens its balance sheet and hinders access to new financing, as firms’ capacity to repay deteriorates.

This negative effect was seen in the balance sheet of Nigerian Banks, following the 2016 devaluation of the currency.

However, this effect depends on the currency in which revenues are earned, that is, whether revenues are in foreign currency or in local currency, according to the IMF.

Exporting firms that use the US dollar or euros for both pricing and financing, are “naturally hedged” as liabilities and revenues move in tandem when exchange rates fluctuate.
“This means foreign currency financing is less of a concern when concentrated in exporting firms. Revenues and liabilities of importing firms, however, are typically not matched, and exchange rate fluctuations bring about balance sheet effects that constrain financing and import volumes. Dominant currency financing tends to amplify the effect of a country’s depreciation on its imports,” the IMF said.

Conclusion: Policy Makers need to Pull other levers
The IMF notes that its analysis on dominant currencies suggests that the weakening of EMDE’s currencies is unlikely to provide a material boost to their economies in the short term as the response of most exports will be muted, besides the physical disruptions to trade from supply and demand disruptions.

Meanwhile, key sectors that would normally respond more to exchange rates—like tourism—are likely to be impaired by COVID-related containment measures and consumer behavior changes.

Additionally, the global strengthening of the US dollar—which mainly reflects a flight to safe haven assets—is likely to amplify the short-term fall in global trade and economic activity, as both higher domestic prices of traded goods and services and negative balance sheet effects on importing firms, lead to lower import demand among countries other than the United States.

“Exchange rates still have a role to play to contain capital outflow pressures and support the recovery over the medium term, but sustaining the domestic economy in the short term requires a decisive use of other policy levers, such as fiscal and monetary stimuli, including through unconventional tools,” the IMF concludes.

See full report here.

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