Last Monday, August 5, China let the yuan fall to its lowest value in more than a decade.¹ Shortly thereafter, the U.S. Treasury Department labeled China a “currency manipulator,” prompting media speculation that the current trade war may pivot into a currency war. Unsurprisingly, these developments rattled investors, leading stocks to suffer their largest one-day decline of 2019. Amid this noise, investors are left wondering how to interpret China’s currency move and what it may signal for the future of this historic bull market.
How Currency Exchange Rates Affect Global Economies
While we use currencies as a medium of exchange and a store of value, they are also traded in the financial markets by speculators and hedgers seeking financial gain. As currencies are bought and sold, they are no different than any other financial asset or product good in that all are subject to price change. And what determines the price of any financial asset or good? Supply and demand.
Outside of financial speculation, which aspects of the real economy most affect the supply and demand dynamics, thus driving the value of currencies? There are two primary drivers: international trade and central bank action. The key here is international trade, since central bank action is often a consequence of the underlying international trade dynamics and how they are affecting the domestic economy.
Following is a breakdown of how the price of currencies affects international trade positions and flows, which, in turn, further affects the currencies’ prices:
- A country that exports more than it imports runs a trade surplus. Conversely, a country that exports less than it imports runs a trade deficit.
- More-developed countries typically run trade deficits, as they import goods from developing nations where the costs of production are typically less expensive. This frequently leads to trade surpluses in the developing nations.
- Countries with trade surpluses should see their currencies appreciate, given that demand for their currencies increases relative to supply as importing countries exchange into the exporting countries’ currency.
- Conversely, countries running trade deficits should see the value of their currencies fall for the opposite reason: needing to sell their currencies in order to exchange them into the exporting countries’ currencies.
As a result of this process, the exporting country now has an abundance of currency from the importing country and needs to do something with it. Typically, that country will do two things: lend the money to foreigners and buy assets from foreigners. So, in addition to currency movements resulting from trade flow, changes in countries’ capital accounts also result in demand for certain currencies at the expense of others.
What’s a Central Bank to Do?
In response to a currency perceived as too strong or too weak, a central bank can raise or lower interest rates to affect the supply/demand dynamic of its currency. If the bank thinks its currency should be stronger, it will go into the market and buy the currency, thus removing some of it from circulation. This reduces the supply of currency relative to the underlying demand, thus raising the currency’s price (i.e., strengthening the currency). Conversely, if the bank thinks its currency should be weaker, it can do the reverse: sell additional currency to increase the supply relative to demand, which will lower the currency’s price (i.e., weaken the currency).
The Dynamics of Free Trade
Taking this to its logical conclusion, in a free-trade regime, the following dynamic should play out:
- The currencies of trade-deficit countries should strengthen as demand for their currencies increases.
- This should, in turn, begin to make their products less competitive on the global market as the real price rises for international buyers, thus leading to smaller trade surpluses for those countries. Similarly, products from countries with trade deficits become more competitive, thus leading to a reduction of the trade deficit.
- As the pendulum for each country swings toward the middle, trade-deficit countries begin to run a surplus and vice versa for trade-surplus countries.
- Eventually, the former trade-deficit countries that are now running trade surpluses will see their currencies depreciate enough that the surplus dwindles. The pendulum will again reverse itself for both the trade-deficit and trade-surplus nations.
In summary, the price of goods—as a function of currency movements—forms a self-correcting mechanism within free-trade regimes. This means that when the cycle of free trade runs its self-correcting course, countries can run neither a trade deficit nor a trade surplus indefinitely.
Any actions that artificially impact currencies could alter this self-correcting dynamic within free-trade regimes. An example of this is an action that leads to currency depreciation meant to keep a currency artificially lower for longer than the mean-reverting mechanism would allow on its own. For starters, this could be the aforementioned intervention by central banks; rather than letting a mean-reverting negative feedback loop process play out, the central bank steps in to keep the currency moving in the same direction.² This could lead other central banks to follow suit, thus creating a prisoner’s dilemma³ by which all currencies suffer relative to alternative currencies (e.g., precious metals).
This brings us back to China’s recent action: simply put, depreciating the yuan is its attempt to maintain the Chinese economy’s status as a strong net exporter in the face of internal weakness and what they perceive as unfair U.S. tariffs. The concern here is that parties are not letting market forces run their course on international trade. The idea that China may further depreciate the yuan has investors concerned about the potential amount of disruption not just to international trade, but also to the natural flow of trade that would occur outside this intervention.
What are the potential consequences? In the short term, there is likely to be continued volatility in corporate supply chains as companies figure out the most effective locale to source product under the ongoing trade dynamics. Economic figures show China is suffering more stress than the U.S., and we expect this to continue. However, both countries know failure to reach an agreement benefits no one in the long run. The question is how long until, and under what conditions, an agreement is reached so that 1) trade occurs under terms both parties are comfortable with, and 2) the natural market mechanism can appropriately value currencies to everyone’s satisfaction.
¹ Since 2008, The People’s Bank of China has held the yuan below a symbolic 7-to-1 ratio. Following last week’s drop, it is now trading at just over seven yuan to the dollar.
² Government intervention (as opposed to “independent” central bank action) can have a similar effect; notably, fiscal deficits that run larger than appropriate as a percentage of GDP within a country.
³ A paradox in decision analysis in which two individuals or parties acting in their own self-interests do not produce the optimal outcome.