Weaker dollar poses threat, says World Bank report

By Reshmi Basu

New York, April 6 - The World Bank warned that the unwinding of global financial imbalances will impact external financing conditions for emerging markets as they are particularly vulnerable to changes in interest and exchange rates.

In the past few years, the combination of such factors as structural reforms, improvements in the external environment and macroeconomic stability have created a favorable cycle of trade surpluses, foreign exchange reserves, low inflation, and growth prospects, the bank said in its 2005 Global Development Finance report.

Those developments have helped the recovery of private capital flows in the past two years, noted the bank in its report. Higher oil prices and fixed exchange rates have also been contributing reinforcements, resulting in a large buildup of foreign currency assets with monetary authorities and central banks in some emerging markets.

"But the increasing size and complexity of external balance sheets pose new challenges that will require not only appropriate strategies to manage external assets and liabilities, but also attention to the domestic macroeconomic implications of higher reserve levels," the bank reported.

Those countries with structural weaknesses in banking and financial systems, high debt loads or a legacy of macroeconomic mismanagement are particularly vulnerable when the country risk is reassessed, noted the bank in the report.

The bank warned that a sharp decline of the dollar could result in substantial capital losses in local currency terms for economies with large dollar reserves.

But some markets will benefit given that a weaker dollar reduces their real net external debt burden as measured in domestic currency.

"Countries that have accumulated large dollar-denominated reserve holdings face acute pressures and large potential investment losses from the weakening dollar, though their dollar-denominated debt burdens may ease," the bank said in its report.

The magnitude will depend on both the amount of dollar-denominated debt and the amount of dollar depreciation, commented the bank. As an example, the ratio of debt service to exports in Brazil has fallen by 10%. Countries whose currencies have fallen against the dollar saw their debt service burden rise, the report noted.

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