Washington DC June 4 2023: IMF study finds that policy interventions to smooth excessive volatility in currency market along with enhancing financial development is necessary to save firm productivity growth in Emerging Markets.
Exploring cross-country heterogeneity, dollar exchange rate volatility severely impacts firm productivity growth in Emerging Markets with low level of financial development, high dollar invoicing, high bilateral trade with the US and open capital account. In addition, IMF study shows that Foreign Exchange Interventions (FXI) policies could dampen this impact on firm productivity in EMs.
No single exchange rate regime is right for all countries or at all times.
The results for instance point to the role of enhancing financial development, reducing financial vulnerabilities but also policy interventions to smooth excessive volatility.
A deeper look at the data, exploiting firm level heterogeneities shows that dollar exchange rate volatility operates through the financial friction channel, causing firms (especially those with low liquidity buffers and a weak balance sheet) to delay their investment.
These results are corroborated using age as an exogenous proxy for the degree of financial constraint at the firm level, as younger firms are found to be more vulnerable to dollar exchange rate volatility in EMs. In addition, uncertainty about the dollar exchange rate operates also through the real option channel as the IMF finding provides evidence for a large and persistent effect on firms with highly irreversible investment. These findings are robust to a battery of tests, including controlling for uncertainty and using an instrumental variable strategy based on using US monetary policy shocks as exogenous source of variation in dollar exchange rate volatility.
Overall, IMF findings suggest the relevance of both the trade and the financial friction channels of the dollar exchange rate volatility with the implication that uncertainty regarding the dollar exchange rate plays an importance role in EMs. The first to the best of IMF knowledge to provide evidence of the effect of dollar exchange rate volatility on productivity growth in EMs.
An important policy implication of IMF findings is that prolonged periods of dollar exchange rate volatility could have important spillover effects on the productivity growth in EMs causing a drag on growth in these countries.
It shows therefore that not only the level but also the second moment of the dollar exchange rate, uncertainty about financial conditions, matters. However, it is important to highlight that the IMF findings should not be construed as suggestive that EMs would be better off with fixed or managed exchange rate regimes.
Fixed or managed regimes have other drawbacks such as the loss of monetary policy autonomy and the inability to use the exchange rate as a shock absorber. The results for instance point to the role of enhancing financial development, reducing financial vulnerabilities but also policy interventions to smooth excessive volatility. Further, there is also room for the development of hedging instruments to help manage such volatility.