Dominant Currency Shocks and Foreign Exchange Pressure in the Periphery

Abstract

The spillover effects of strong dollar and euro, two dominant currencies, on emerging market economies (the periphery) are examined. This paper empirically studies the dominant currency shocks on foreign exchange (FX) constraint, economic growth, external debt, and inflation. Comparing the dollar shock to the euro and commodity price shocks and employing various empirical methodologies across regimes of trade invoicing and commodity dependence, this paper shows that appreciation of the trade weighted exchange rate (the dollar index) can worsen 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.

Keywords: dominant currency, exchange market pressure, international monetary system, nominal spillovers, ‘original sin’

JEL Classification: F39, F40, F41, F44, F62, O11