1.5 New challenges meet existing vulnerabilities in the financial sector

bRAVIng tHe PeRfect stoRm

does not change, the dollar price is sticky in the short term and the euro-dollar exchange rate is assumed unchanged. This leads to no change in export volume. In other words, all the volume adjustment takes place on the import side.

This result may seem counter-intuitive, as one would expect the currency depreciation to make goods relatively cheap for European buyers, benefitting Pakistan’s exporters. But in the short term, this mechanism is often muted. For example, when the Pakistani rupee depreciated rapidly against the US dollar in 2019, Pakistan’s exporters did not expand shipments as fast as expected (Ahmad 2019), even though the depreciation gave them a price advantage relative to competitors. Brun, Gambetta, and Varela (2022) show that part of the low export response to depreciation is related to dollar price stickiness and US dollar invoicing.

During the most recent dollar rally, as the euro also depreciated against the dollar, European consumers face higher euro prices of imports from Bangladesh, because the bilateral trade is invoiced in the US dollar and the dollar prices are sticky in the short term. As a result, Bangladesh exporters do not benefit from the taka depreciation visà-vis the dollar.

While the above example illustrates how the invoicing currency matters in bilateral trade, the impact depends crucially on sticky prices in the short term. Over time, as exporters adjust prices, both the exports and imports will fully adjust to reflect movements in the bilateral exchange rate (e.g., the rupee-euro exchange rate). Nevertheless, the impact of dollar invoicing is particularly relevant now and for emerging economies (Boz et al. 2022).

1.5 New challenges meet existing vulnerabilities in the financial sector

Equity market indexes drop as investment sentiment deteriorates with only India showing resilience. As advanced economies started monetary tightening earlier and more aggressively than some of the South Asian countries (e.g., India and Bangladesh), the interest rate differential with the U.S. narrowed, making the South Asian markets relatively less attractive to investors. At the same time, investor appetite for risk shifted due to heightened uncertainty following the war in Ukraine. As a result, investors withdrew funds from the South Asian markets, and major stock indexes dropped in February and underperformed the S&P index in the spring (Figure 1.17.A). During May-July, as South Asian countries sped up monetary tightening, the region’s markets outside of Sri Lanka performed better than the world