US Dollar has played a dominant role in global transactions, from cross-border capital flows to trade. According to IMF, US Dollar accounted for approximately 40 percent of cross-border Swift flows as of the end 2021. About half of the global trade used USD as invoicing currency by the end of 2022. With further global financial integration, US monetary shocks can spill over to emerging countries through exchange rate fluctuations and be further amplified by volatile cross border capital flow. A study by ACI investigates the differential impact of US monetary spillovers into emerging market economies (EMEs) of different riskiness and their optimal monetary policies.

The study constructed a banking sector risk index to measure the riskiness of over 20 EMEs. The figure below plotted the differences in GDP and stock market responses to US monetary shock for EMEs of different risk profiles. The blue dashed lines captured the differences in response between the riskier (at the 75th percentile of each risk exposure measure) and safer EMEs (at the 25th percentile of each risk exposure measure). It shows that EMEs with higher trade connections with the US suffer larger declines in GDP after a contractionary US monetary shock. Higher banking risk also contributes to a larger GDP decline. EMEs with high banking sector risk would witness a larger decline in GDP from the pre-shock level by 1 percent compared to EMEs with low bank risk. This indicates that banking sector risk amplifies the negative impact on emerging countries’ real economy and financial market due to contractionary US monetary shocks.

A two-country DSGE model with financial frictions in both the US and the emerging economy can help to account for the above findings. The study incorporated a new modelling feature that by investing in riskier EMEs, US investors face a tighter financing constraint, thus require a higher return from the EME in the deterministic steady state. It was found that riskier EMEs experience a larger decrease in output and consumption. The drop in consumption is mainly accounted for by the reduction in imports: As home currencies of risky EMEs depreciate more after the US interest rate hike, imported goods become more expensive and therefore, the consumption of imports decrease by more in riskier EMEs. Additionally, there is a larger capital outflow and steeper asset price decline in riskier EMEs, following an unexpected US monetary shock.

The article compares the households’ welfare for EMEs with different riskiness, under different monetary policies and argued that optimal monetary policies differ in emerging countries with different riskiness. For risky EMEs, exchange rate stabilizing monetary policies tend to exacerbate household welfare losses. For safer EMEs, however, fixed exchange rate policy can outperforminflation targeting policies and better protect domestic household welfare.

The different optimal monetary policy implications for the riskier and safer EMEs are mainly driven by the higher real interest rate of riskier EMEs that commit to peg compared to their safer counterparts. The uncertain future of monetary policy poses investment risks for US banks, prompting them to diversify and mitigate those risks. The results of the study indicate that in anticipation of future US monetary policy shocks, US banks would increasingly invest in EMEs, particularly safer EMEs, while reducing their exposure to domestic assets in the stochastic steady state.

By LIU, Jingting, HUANG, Yijia

Researchers: LIU, Jingting, CHIA, Wai Mun