In an era of increasing global financial interconnectedness, understanding how monetary shocks in a major economy like the United States ripple through the world has become crucial. This intricate question has profound implications for policymakers and economists, especially in emerging economies, who must navigate the complexities of our interconnected financial world while striving to maintain stability and growth. A recent paper by ACI delves into this tangled web of international finance and economics, shedding light on how country heterogeneities influence the propagation of US monetary shocks.

Traditionally, economists have grappled with the policy trilemma, which hypothesizes that a country can only achieve two out of three goals: free capital mobility, fixed exchange rates, and monetary autonomy. However, this neat framework has come under scrutiny in an age of heightened financial integration, where monetary shocks in center economies can affect peripheral countries regardless of their exchange rate policies. This raises a critical question: how can peripheral nations protect themselves from the impact of monetary shocks emerging from larger economies?

The research focuses on the interplay of two significant factors: a country’s net exposure to the US dollar and its degree of financial openness. These elements play a pivotal role in determining how emerging economies respond to US monetary shocks. The researchers used a two-step method. First, they simulated how US monetary shocks affect interest rates and GDP in peripheral countries. Then, they examined how these responses were linked to different country-specific factors.

The results indicate that countries with a high degree of liability dollarization and financial openness will face a double whammy in the face of higher US interest rates.  In particular, countries with higher levels of debt dollarization, or a greater reliance on US dollar-denominated borrowings, tend to react by raising domestic interest rates significantly when confronted with contractionary US monetary shocks. This response is aimed at mitigating the negative balance sheet effects stemming from fluctuations in the value of their dollar-denominated debt. Moreover, if these countries are also highly exposed to the global financial market, their GDP could face even more pronounced declines as international investors pull back investments while US interest rates surge.

A policy problem that preoccupies policymakers is whether they should employ capital flow management measures to protect their countries against external financial market disturbances. The authors argue that the effect of such policies may vary across countries. The study shows that while capital control may help dampen the negative spillover effects of US monetary policy contraction, the benefit is larger for countries with higher levels of debt dollarization.

These findings suggest that policy trilemma might have transformed into a dilemma that challenges the policy space, as policymakers have to carefully tread between accommodating economic downturns while not disrupting financial stability. Hence, the ability of emerging market economies to shield against the aftershocks of external financial market disturbances hinges on a delicate balance of financial openness, debt exposure, and prudent policy measures.

By XU, Ni Scarlet

Researchers: LIU, Jingting, TAN, Sook Rei, CHIA, Wai Mun