Does a weakening dollar matter?

On the effect of Exchange rates on Latin American economies

Whether it is to travel during the holidays, pay tuition fees, or help their families abroad with some money, most people have had to deal in some way or another with the concept of exchange rates. Just as any other, the foregin exchange market plays a key role in the economic dynamics of any country, and not just on those related to international trade.

Sovereign bond yields, for example, are affected by exchange rates, which in turn affect the government finances, having an important impact in different sectors of the economy. For some countries, exports represent large shares of the GDP, and thus, small changes in the exchange rates can translate into dramatic changes in economic performance: from joyful booms to disastrous catastrophes. Low-income economies, on the other hand, rely heavily on remittances, and for many, they could be the difference between destitution and prosperity. It is clear, exchange rates are not something the average citizen should decide to ignore, since it has a massive impact in their lives, either directly or indirectly. Neither should businesses or governments. 

In the light of Covid-19, different national governments and central banks have taken important decisions regarding monetary and fiscal policy. These actions have had important effects on inflation, debt, unemployment, but also on exchange rates. Many developed economies like the United States, the United Kingdom, and those who are part of the European Union have committed to undertaking expansionary monetary and fiscal policy in an effort to mitigate the negative effects from the reduced levels of economic activity product of simultaneous supply and demand shocks. These policies in turn can cause their currencies to depreciate, and this has been the case for the US dollar.

On the other hand, large numbers of developing countries haven’t been able to conduct these kinds of policies (at least not at the same level as developed economies) because of many reasons, including the high cost of borrowing, technical difficulties arising from the size of the informal economy, and pandemic-related capital flights. Many of these countries are located in Latin America, a region with many historical examples of high inflation and fiscal deficits even before the pandemic.

All of these decisions (and in some cases, the lack of them) have played an important role on how emerging economies have fared during the pandemic and will determine the way out of the global recession. It is worth asking then, how have the monetary and fiscal policy decisions of developed economies affected developing countries’ economic performance during the Covid-19 pandemic? In this article we will discuss how the US monetary and fiscal policy, and especially its influence on exchange rates, has affected Latin American markets and their ability to recover.

The US economic response to the Covid-19 pandemic

Since March 2020, The US Federal Reserve has implemented an expansionary monetary policy. That is, through different monetary tools, the Fed has kept the fed funds rate low in order to encourage lending and stimulate economic activity. Not only have they reduced the fed funds in 1.5 percentage points to near zero interest rates, but have also made use of forward guidance, which is the practice of announcing the intentions of the central bank in the future to influence the expected inflation.

Apart from the more traditional monetary policy tools, the Fed has also introduced novel tactics to fulfill its mandate, including the controversial quantitative easing (or QE). According to an article from Brookings, “the Fed’s portfolio of securities held outright grew from $3.9 trillion to $6.6 trillion”. All of these measures have pushed interest rates low, encouraging investors to shift to more profitable assets abroad, therefore causing the dollar to lose value.

Figure 1: Effective Federal Funds rate, 2015-2021

Additionally, the US Congress have already approved more than 3.5 trillion dollars in fiscal stimulus, while a new $1.9 trillion package is being discussed in the Senate at the time of writing. This massive economic stimulus has had a similar effect to that of the Fed’s monetary policy, and although being effective in helping families in the US and encouraging lending, has had a downward pressure on the dollar.

Now the question is: how does this loss in value of the dollar affect Latin American economies? We will analyse four distinct effects on different types of economic phenomena: these are Remittances, Commodity prices, Dollarisation, and Foreign Debt.

Case I: Remittances – Honduras

When the World Bank estimated that remittances would decline by 14% worldwide due to the global pandemic, countries like Honduras were watching closely. With 20% of the country’s GDP coming from remittances, this shock would prove to be disastrous in an already difficult region. However, the outcome turned more positive than expected: According to the Atlantic Council, remittances to Honduras increased by 15% between June 2019 and June 2020. This might be due to the fiscal stimulus implemented in the United States, the appearance of many essential jobs and changes in the pattern of changes. Most recent data shows that remittances in the country have increased from $380 million in January 2020 to $450 in the same period in 2021, an increase of 17.3%.

Figure 2: Countries by total remittances received as a share of GDP

However, not everything is good news for Honduras, since the depreciating dollar has made these remittances less valuable in the country. The HNL/USD exchange rate moved from 25 in May 2020 to 24.09 in January 2021, a reduction of 3.64%. It is also worth noting that before the pandemic the Lampera had been depreciating steadily for the last 5 years. This shows that, although in part compensated by the significant rise in remittances, Honduras is experiencing a negative collateral effect of the loss in value of the US dollar. A country where remittances make up a fifth of the country’s GDP, small changes in exchange rates can have dramatic effects in income and living standards. 

Case II: Commodity prices – Colombia

Colombian main exports, oil and coffee, have seen large surges in the last months. The price of oil has risen from 37 dollars per barrel in October to 66 by the time of writing, which is a dramatic increase. Coffee, on the other hand (normally with opposite dynamics to the value of the US dollar), has risen from $1.03 in November to $1.4 in February. All of this has allowed Colombia to raise exports. Despite this relatively favourable setting, exports in February reported a reduction of 24% with respect to last year, driven mainly by the drop in 42% from the sales of the petroleum sector.

Figure 3: Total exports by month, Colombia

Being traditionally a commodity-exporting country, Colombia has been affected not only by the drop in production because of Covid-19 but also because of a drop in exports, which represent roughly 16% of GDP. The effect of currency appreciation of the Colombian peso against the dollar hasn’t quite helped the country in increasing exports and should be a point of concern on the way of the pandemic crisis.

Case III: Dollarisation – Ecuador

Dollarisation has always been a very contested policy tool, because although it might help reduce inflation and interest rates, it makes the country unable to conduct monetary policy whatsoever and forces it to rely on international reserves to prevent a financial crisis. One of the countries which relatively recently decided to take this step was Ecuador, who in the 2000s decided to establish the United States dollar as the official currency of the nation.

The depreciation of the dollar has two implications then for Ecuador: on one hand, oil exports (one of the main sources of revenue for the country) will be more competitive in the market, but on the other, imports will become more expensive and there might be risks of inflation. There is not much the Ecuadorian economic institutions can do to correct the exchange rate effects product of international financial markets and US monetary and fiscal policy. The situation is beneficial for now, but if the dollar appreciates again, the hit on Ecuadorian exports could be significant and the government might be unable to compensate for its effects. This is the dollarisation dilemma: stability or independence. A tough choice in the light of Covid-19.

Currently, Ecuador is debating the possibility of enacting a “Defense of the Dollarisation” Bill, tied to some economic commitments demanded by the IMF to provide assistance during the crisis. The discussion of dollarisation is appearing again in the public debate and will probably intensify after the upcoming elections. In some sense, the US monetary policy is playing an important role in the political future of Ecuador.

Case IV: Foreign Debt – Argentina

Nonetheless, not everything is bad news for the continent, and in particular for one country that has plenty of experience with them. The case of Argentina has always been a puzzle for economists and a new agreement with the IMF seems very close. A recession of -12% in 2020 is just another blow for the southern country which has struggled to introduce structural fiscal and monetary reforms for many years. Significant pressure has mounted over the government because of the fears of default on foreign debt which was at $323 billion back in August.

The depreciation of the dollar in recent months and the increasing “dollarisation of the debt” will provide some relief to Argentina, as loans become relatively cheap since tax revenue is now worth more value. However, this depreciation of the dollar would make exports to the United States (which is the third largest imported of Argentinian goods) less competitive and therefore could reduce income originated from exports.

Figure 4: GDP per capita change in Latin American countries

Not only Honduras, Colombia, Ecuador, and Argentina have been affected (positive or negatively) by the recent depreciation of the dollar. Virtually every country in the region and in the world depends on the US market in one way or another, and therefore it is crucial to study the impact of its economic policy. Countries should be resilient and ready to respond to changes in the US monetary and fiscal policy, in order to reduce the risk of collateral effects on interest rates, exchange rates, trade and even debt. These times should shed light on the increased level of globalisation and should encourage study of its benefits and risks.

This article was written by: Roberto Patiño, currently a student at the London School of Economics, pursuing BSc Mathematics and Economics

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