Understanding the relationship between international trade and currency exchange rates will help you invest in currencies to build your portfolio. Countries are frequently renegotiating international trade deals to get a comparative advantage. When one country makes a significant change, it can affect the value of currency in other countries. There are several ways international trade deals can affect currency exchange rates.
5 WAYS INTERNATIONAL TRADE AFFECTS CURRENCY RATES
- Exports Increase
- International Investments Increase
- Deflation or Inflation in Another Country
- Imbalance of Exports and Imports
- International Trade Disputes
In order to understand how international trade affects currency rates, it’s important to discuss two economic concepts: balance of trade and currency exchange rates. Every country has a balance between imports and exports. Since this balance of trade is never net zero — meaning imports and exports are never equal — this affects the supply and demand of a nation’s currency. In turn, any change can affect the price of its currency in the world market. While striving to acquire a comparative advantage when it comes to foreign import and export controls and customs regulations, countries frequently negotiate and alter international trade deals.
Every country has a currency exchange rate, which is a relative value. For instance, at the time of this writing, one euro is equal to 1.13 US dollars. Based on this base ratio, you can accurately estimate all other exchange ranges between the two currencies–for instance, five euros is equal to 5.65 US dollars, ten euros to 11.30 US dollars, and twenty euros to 22.61 US dollars, and so on. An American investor, exchanging dollars for euros, would buy 1.13 euros for every dollar sold. Conversely, a European investor in the Eurozone would buy one United States dollar for every 1.13 euros sold.
1. Exports Increase
In order to increase its exports, a country’s currency must weaken. Although a weak currency may sound like a negative thing, it helps to increase a country’s export market share because its products are now relatively less expensive compared to the price when its currency was stronger. The increase in sales and revenue result in new economic growth, for both new companies and expanding existing companies. Companies who do any business in or with foreign markets are now incentivized to hire more people and improve their product line to increase profits.
Here’s a hypothetical example to make this point a little clearer:
Country A’s exports will noticeably increase if its currency value drops. Other countries will realize that purchasing items made in country A are less expensive than buying them from other countries with stronger currencies. When a nation’s exports gain more market share because its products are less expensive than the countries with stronger currencies, an increase in sales will improve both economic growth and job creation. This new prosperity will not only increase the corporate profits of companies that conduct business in foreign markets, but the country will also earn higher revenues from taxation, like sales tax, corporate tax, and income tax on a larger labor pool.
2. International Investments Increase
When a country’s prices drop, international investments will rise because the country will be earning more from exports. Foreign investors and multinationals are attracted to countries with more economic growth as this helps them earn handsome profits.
3. Deflation or Inflation in Another Country
With a global economy, trade deals, imports and exports, and foreign investments can fluctuate when single a country’s currency changes. When a country has low economic growth, deflation arises. Deflation has two profoundly adverse effects. First, since consumers expect prices to continue to drop, they may postpone spending so that they can buy goods and services at a lower price. Second, since businesses expect their revenues to fall, they delay investing in their business, spending less money on R&D to spur innovation and spending less on advertising to market their products. As a result of consumers deferring spending and businesses postponing investments, economic activity continues to spiral.
But while low economic growth results in deflation, the opposite happens when a country experiences a surge in economic growth. When a country increases its economic growth because of a weaker currency, inflation rises when buying from a country with a stronger currency because it requires a larger amount of the weak currency to buy the same quantity of goods and services priced in a comparatively stronger currency.
While deflation results in a sluggish economy, a downward spiral of consumer spending and corporate investing, inflation, arising from a weaker currency, is an upward trend of consumer spending and corporate spending. Of course, if inflation gets out of control, it could have negative consequences — more money is required to buy the same quantity of goods and services. This can then lead to a situation called stagflation, which results when chronic high inflation together with persistently high unemployment creates stagnation in demand. So, while a little inflation might be an economic stimulus, too much can cause economic and currency exchange rate problems.
However, one positive aspect of inflation is that it provides relief for debtors. Since the value of the debt remains unchanged, it now becomes easier for local borrowers to pay down their debts. However, if the debt is owed to foreign investors and priced in their higher currency, the debt does become far more expensive. As a result, repayment of the debt often tends to occur at a slower rate.
4. Imbalance of Exports and Imports
Supply and demands of goods and services, as well as supply and demand for currency, are affected by the balance of exports and imports. If a country exports far greater value than what it imports, it will enjoy a positive trade balance known as a trade surplus. In this case, its supply of goods and services is far greater than what it demands from other nations. On the other hand, if a country imports far greater value than what it exports, it will suffer a negative trade balance, known as a trade deficit. In this case, its demand for goods and other services is far greater than what it supplies to other nations.
Sometimes, geopolitical issues interfere with the flow of supply and import-export balance. Consequently, economic sanctions, trade barriers, tariffs, trade policy disputes may cause one country to be unable to break away from a negative trade balance even if its currency pricing and products are highly attractive. Additionally, second world countries, which are former communist and socialist industrial nations, have their own bilateral trade agreements that are not necessarily oriented toward globalization and free trade principles.
5. International Trade Disputes
Investors experience gains and losses because a free enterprise global trade market is determining the value of a currency in relation to other currencies. However, when it comes to the complexities of trading economics, free trade principles don’t always determine prices. Sometimes, currency rates may be changed as a result of trading policies enacted by a country’s international trade commission or its international trade administration. For instance, according to recent international trade news and international business news, the current U.S International Trade Commission is waging an economic trade war on China’s alleged unfair trade practices by finalizing tariffs on USD $200 billion worth of Chinese imports.
Since world trade does not always align with international trade theories, numerous international trade laws have been codified. In addition to conflicts over international trade agreements between countries, there are also intra-industry trade disputes and anti-money laundering schemes. These are intricate issues that international trade lawyers and judges with extensive experience strive to legislate. Consequently, not only is there a World Trade Organization, an intergovernmental international trade organization responsible for regulating international trade agreements between foreign countries, but every country, too, has its own court of international trade. In the United States, for example, the US Court of International Trade, which falls under Article III of the nation’s Constitution, and the U.S. International Trade Commission handle a wide range of international trade organization legal issues.
How International Trade Affects Currency Rates
It’s useful to understand the relationship between international trade and currency exchange rates if you decide on a long-term buy-and-hold currency strategy, buying one currency at a low rate, wait for it to revalue, and then sell it at a higher price.
It’s also helpful to understand the relationship between international trade and currency exchange rates if you want to trade in the foreign exchange market, FOREX, the world’s largest over-the-counter market for currency trading that determines almost everything to do with buying and selling currencies.
When trying to understand the benefits of international trade and currency exchange rates, you have to keep in mind that it’s all about relative values, compared to absolute values. Countries are constantly changing their economic policies and banking regulations, as well as frequently renegotiating international trade deals to get a comparative advantage in international trade.
When currency is based on a floating strategy, it influences a nation’s demand for its currency. This, of course, also influences its international trading strategies. If a country manages to export far more than it needs to import, this not only means that there is a high demand for its goods, but also a high demand for its currencies. Naturally, the opposite happens if a country is forced to import more than it can export. Now, currency investors and businesses decrease their demand for the country’s currency. As prices subsequently decline, it depreciates the currency. The currency now starts to rapidly lose value.
By understanding basic economic principles like the balance of trade and currency exchange rates, as well as understanding how strong and weak currencies affect trade, inflation and deflation, supply and demand, it becomes easier to decide when to buy, sell, or exchange currencies.
Incidentally, in those cases, where a country has a pegged currency, which is a currency that is fixed by regulations, the exchange rate is less responsive to trade balances and imbalances and does not change much. There is little benefit in investing because profitable currency trades are usually based on currency volatility, rather than stability.
If you would like to learn more about trading and foreign investments, then you might find it helpful to join an International trade group and subscribe to reputable publications like International Trade Today. There is much more to learn. For instance, you might be interested in learning more about South-South trade, the rapid growth of international trade created preferential trade agreements between many developing countries or you might be interested in finding out more about how the transpacific-partnership (TPP) effectively rewrote the rules of global trade.