The U.S. dollar has surged to peaks not witnessed in two decades, a consequence of the Federal Reserve’s aggressive interest rate hikes since March 2022 aimed at curbing persistent inflation. This rise, coupled with the perceived stability of the U.S. economy, has amplified the dollar’s allure, triggering a ‘flight to safety’ within international capital markets. Simultaneously, the conflict in Ukraine has destabilized European energy markets, and ongoing COVID-19 related shutdowns continue to impede China’s economic growth. For developing nations, the strengthening dollar translates to a multitude of challenges: escalating import costs, amplified inflationary pressures, rising debt servicing burdens, increased borrowing expenses, and deteriorating fiscal and current account balances. These factors collectively undermine their prospects for a robust economic recovery from the pandemic’s impact.
Currency in Crisis: Depreciation and Capital Flight
Over the past year, the U.S. Dollar Index has dramatically increased by approximately 20 percent against a spectrum of global currencies (Figure 1). Particularly between June and September of this year, the index reached historic highs as the Federal Reserve implemented substantial policy rate increases totaling 225 basis points.
This global interest rate shockwave has spurred significant capital outflows from developing economies. This capital flight is largely motivated by the higher yields now offered by long-term government bonds in advanced economies, coupled with investors’ pursuit of safer investment havens. Consequently, between March and July 2022, developing and emerging markets experienced an outflow of nearly US$32 billion.
U.S. Dollar Index Climbs as Interest Rates Rise
Against this backdrop of international investors reducing their exposure in developing markets and the resultant capital outflows, numerous developing country currencies have experienced significant depreciation against the U.S. dollar throughout 2022. Currencies like the Argentine peso, Pakistani rupee, South African rand, Indian rupee, and Indonesian rupiah have all weakened considerably against the dollar since the beginning of 2022 (Figure 2). However, some Latin American currencies, such as the Mexican peso and Brazilian real, have shown resilience during the first half of 2022, bolstered by stronger commodity prices. In response to these pressures, many central banks in developing countries have actively intervened to slow down currency depreciation by utilizing their foreign-exchange reserves. However, for certain developing economies, managing this currency adjustment has proven challenging, especially given their limited reserves of liquid assets.
Exceptions to the Rule: Currencies Defying the Dollar’s Rise
Interestingly, several currencies within the Commonwealth of Independent States (CIS) have bucked this trend, appreciating against the U.S. dollar. The Russian ruble, despite an initial steep decline at the onset of the conflict in Ukraine and the imposition of widespread economic sanctions, staged a remarkable recovery. Paradoxically, it became the world’s best-performing currency in terms of appreciation against major global currencies (Figure 3). This surge in value occurred despite Russia facing double-digit inflation and economic contraction, and with half of its central bank’s overseas reserves frozen.
This anomaly can be attributed to a combination of factors. Following the ruble’s initial fall, the Russian central bank drastically increased its policy rate and implemented stringent capital controls. Furthermore, the government mandated that exporters sell a significant portion of their foreign exchange earnings on the domestic market, thereby increasing demand for the ruble. Additionally, European gas importers were required to convert their payments for Russian gas into rubles. Concurrently, Russia’s current account balance improved due to elevated hydrocarbon prices and increased oil exports to Asia, while imports decreased due to sanctions. As a result, Russia’s current account surplus reached an estimated US$183.1 billion between January and August 2022, significantly higher than the US$60.9 billion recorded during the same period last year. Similarly, while most CIS currencies initially depreciated sharply after the Ukraine conflict began, this trend reversed quickly due to substantial capital inflows from Russia. Many CIS countries and Georgia absorbed significant capital inflows from the Russian Federation. For example, money transfers from Russia to Armenia nearly tripled in the first half of 2022 compared to the same period last year, exceeding US$1 billion, as many Russian nationals and businesses, including the export-oriented IT sector paid in dollars, relocated to these nations. However, this phenomenon is likely temporary, and these countries may face considerable downside risks if these flows reverse.
Currency Depreciation Against the U.S. Dollar in 2022
Debt Distress: The Dollar’s Impact on Developing Nation Liabilities
A stronger dollar significantly exacerbates the external debt burdens of developing countries. This vulnerability stems from the fact that a large proportion of their external debt stocks and debt service payments are denominated in U.S. dollars. While developing country governments collect revenue in their local currencies, they often service their external debt in foreign currencies, predominantly U.S. dollars. Consequently, when a domestic currency depreciates against the dollar, the country’s debt service burden increases proportionally without a corresponding increase in tax revenue. Developing nations with high levels of external debt are particularly susceptible to sudden tightening of global financial conditions, as many governments rely on short-term borrowing from international capital markets to meet their long-term debt repayment obligations.
External Debt Stock of Developing Countries by Region
In the decade preceding the COVID-19 pandemic, developing countries benefited from substantial capital inflows, particularly in Asia and Latin America. Low interest rates and abundant global liquidity encouraged many to borrow from international capital markets, leading to an increase in external debt across numerous nations. Furthermore, fiscal measures implemented to mitigate the economic fallout of COVID-19 pushed debt levels in some countries to unprecedented highs. According to the World Bank, the external debt stock of low- and middle-income countries rose by an average of 5.6 percent in 2020, with many countries experiencing double-digit increases. Significantly weaker exchange rates, tighter global financial conditions, and sluggish economic growth have amplified debt risks and vulnerabilities throughout the developing world. The most severely affected countries are those where foreign currency-denominated debt constitutes a large share of their exports. For some nations, meeting interest payments to creditors has become particularly challenging, especially those grappling with significant currency depreciations. The proportion of dollar-denominated debt varies considerably across regions (Figure 4). The Middle East and North Africa have a relatively lower share compared to other regions, while in Latin America, it accounted for approximately 90 percent in 2020.
Growth Under Pressure: Economic Headwinds from a Strong Dollar
Beyond debt, a strong dollar can also impede long-term economic growth in developing countries by raising the cost of capital and dampening both public and private investment. As the U.S. Federal Reserve raises interest rates, central banks worldwide often follow suit to prevent capital outflows and mitigate downward pressure on their exchange rates. However, these interest rate hikes elevate domestic borrowing costs, thereby reducing both public and private sector investments.
A strong dollar also inflates import prices, particularly for developing countries heavily reliant on imports to satisfy domestic food and energy demands. The majority of international trade is conducted in U.S. dollars. Between 1999 and 2019, the U.S. dollar was used for invoicing in 96 percent of trade in the Americas, 74 percent in the Asia-Pacific region, and 79 percent in the rest of the world. Europe is the primary exception, where the euro is the dominant currency. While a strong dollar can help manage inflationary pressures within the United States, it has the opposite effect on inflation in developing economies that are net importers of food and energy. In the current geopolitical landscape, a stronger dollar is undermining food and energy security in many developing countries, as the import prices of essential commodities like food grains and oil—when converted to local currencies—have risen sharply in recent months. For example, consider a country importing oil priced at $100 per barrel. If their currency weakens from 1 euro to 1 dollar to a rate closer to, say, 1.165 euros to 1 dollar – reflecting currency fluctuations – the local currency cost of that oil import increases even if the dollar price remains constant. While 165 euros might currently convert to roughly $178, understanding these exchange dynamics is critical for developing economies managing import costs.
Exchange Rate Pass-Through to Inflation in Developing Economies
The “pass-through effect” of a domestic currency’s depreciation against the U.S. dollar varies depending on specific country characteristics. Generally, economies with greater openness to trade and financial transactions, less credible central banks, more volatile inflation and exchange rates, and lower levels of market competition tend to experience higher pass-through effects on inflation. Empirical evidence suggests that economies with significant exchange rate pass-through to domestic prices and high proportions of dollar-denominated debt face a difficult policy trade-off between stabilizing inflation and managing adverse external shocks. The policy challenges for developing countries are now even more formidable. They have limited room to maneuver given persistent supply-side bottlenecks that are exacerbating inflationary pressures and high levels of dollar-denominated external debt.
Dollar’s Reign: How Long Will It Last?
As announced following its Federal Open Market Committee (FOMC) meeting on September 21st, the U.S. Federal Reserve is expected to raise its key policy rate to 4.25–4.4 percent by the end of 2022. Rate hikes are likely to continue into at least the first half of 2023, with significant and adverse spillover effects on developing countries already caught in a downward spiral of slow growth, high inflation, and high unemployment. The deteriorating economic outlook for developing countries will likely further weaken their exchange rates in the near term, intensifying capital outflows and further worsening their financing conditions. In this challenging environment, many developing countries will face a significantly difficult uphill battle to achieve robust recovery, stimulate growth, and make meaningful progress towards the Sustainable Development Goals (SDGs).
Monthly Briefing on the World Economic Situation and Prospects – prepared by the Global Economic Monitoring Branch, UN DESA.
