Dominant currency shocks and foreign exchange pressure in the periphery

Abstract

The spillover effects of a strong dollar and euro, two dominant currencies, on emerging market economies (the periphery) are examined. The paper empirically studies dominant currency shocks on the foreign exchange (FX) constraint, economic growth, external debt, and inflation. Comparing a dollar shock to euro and commodity price shocks, using various empirical methodologies across regimes of trade invoicing and commodity dependence, the paper shows that appreciation of the trade weighted exchange rate (the dollar index) can worsen the FX constraint and decrease growth in the periphery, failing to achieve the conventional macroeconomic adjustments of a competitive currency depreciation. A strong dollar reduces external debt, but a strong euro has the opposite effect. An FX-constraint shock emanating from the periphery appreciates the US dollar, affirming dollar’s safe-haven status. These findings have implications for balance of payments and exchange rate policy management for a larger group of emerging markets and developing economies.