By David Lawder
WASHINGTON (Reuters) - Emerging market economies bore the brunt of the strongest U.S. dollar in two decades in 2022, a rise that battered them with capital outflows, higher import prices and tighter financial conditions, the International Monetary Fund said on Wednesday.
The IMF said new research in its annual External Sector Report shows that the dollar's surge last year had a bigger impact on emerging markets than on smaller advanced economies, partly due to the latter group's more flexible exchange rates.
For every 10% of U.S. dollar appreciation linked to global financial market forces, emerging market economies faced a gross domestic product (GDP) output decline of 1.9% after one year, a drag that is expected to linger for 2.5 years, the IMF said.
The same research showed the impact was far lower in advanced economies, with output reduction peaking at 0.6% after one quarter and the effects largely gone within a year.
The IMF said in the report that the dollar's real effective exchange rate rose by 8.3% in 2022 to its strongest level in two decades, amid a rapid series of Federal Reserve rate increases to curb inflation and higher global commodity prices driven by Russia's invasion of Ukraine.
"Emerging market and developing economies with pre-existing vulnerabilities such as high inflation and misaligned external positions experienced greater depreciation pressures, while commodity-exporting economies benefited from the increase in commodity prices," the IMF said.
Many emerging market economies suffered worsening credit availability, diminished capital inflows, tighter monetary policy, and bigger stock market declines.
In advanced economies, more flexible exchange rates were able to absorb some of the impact through depreciation, while more accommodative monetary policy also helped - provided that there were firmly anchored inflation expectations, the IMF said.
"More anchored inflation expectations help by allowing more freedom in the response of monetary policy. After a depreciation, a country can run a looser monetary policy if expectations are anchored. The result is a shallower initial decline in real output," the report's authors said in a blog posting.
"In turn, emerging market economies with more flexible exchange rate regimes tend to enjoy a faster economic recovery owing to a sizable immediate exchange rate depreciation."
The IMF recommended that emerging market countries move toward flexible exchange rates by developing domestic financial markets that reduce the sensitivity of borrowing to the exchange rates, and commit to improving fiscal and monetary frameworks, including central bank independence, to help anchor inflation expectations.
The External Sector Report showed IMF staff assessed that the dollar was over-valued in 2022 by 3.5% to 14.6%, with a midpoint of 9%. As of April 2022, the IMF said the dollar's value was 0.5% below its 2022 average.
The Fund also said that the euro was over-valued in some eurozone countries, by about 10% in Italy and Finland, while it was undervalued in others, by 8% in Germany.