The Murky Connections between Trade and Exchange Rate

A positive trade balance should result in appreciation of the currency. However, it is in the interest of countries that export large volumes of goods to have a weaker currency.

By Shobitha Cherian and Anupam Manur

The relationship between the strength of an economy and the strength of the currency was discussed in a previous post. The aim of this post is to discuss the conditions under which economies would want to have a weaker currency. Generally, it is in the interest of countries that export large volumes of goods to have a weaker currency.

The exchange rate of a particular currency is determined mainly by the demand and supply of the said currency. By this logic, countries which export large volumes of goods, or which have higher international demand for their goods, would have stronger currencies, or would have a higher value when compared to the reserve currency or the U.S Dollar. This is due to the fact that since their goods are high in demand, so will be their currency. However, in actual practice, one can see that it is favourable for certain countries to have weaker currencies.

Table showing the relationship between trade balance and exchange rates

Table showing the relationship between trade balance and exchange rates

Source: Calculations based on data from World trade organisation and the International monetary fund database.  Note: Since the countries belonging to the Euro zone use a common currency, they have been eliminated from this analysis.

The above set of countries shows the volume of exports as a percentage share of total world exports, the current account balance (difference between exports and imports) and their exchange rate with respect to the US$. The chosen countries are amongst the top 20 exporters.

From the above data set, it is apparent that countries with a significant share of the world export market have currencies that are weaker than the dollar, i.e., more of that currency is required to buy one dollar. The Korean Won and more so the Indonesia rupiah stand out; around 12800 rupiah is required to buy 1US$.

However, merely looking at export data and the exchange rate gives an incomplete picture. Since the exchange rate is determined by a country’s exports and imports, the relevant data to look at is the trade balance (second column). Further, the strength of a currency has to be looked at in terms of changes. The third column gives the percentage change in the value of the currency since 2010 (a positive number reflects appreciation and a negative number means that the currency has depreciated/weakened).

The table above shows the rather murky lines between economic principles and reality. As explained above, a positive trade balance should result in a currency appreciation and vice versa. Only five of ten countries (highlighted in green) follow this rule. Saudi Arabia and the UAE have fixed exchange rate regimes and thus, show no change in the five years despite having a positive trade balance. Japan, Russia and South Korea have very strong trade surpluses, yet their currencies have depreciated during this period. The Russian rouble has depreciated by over 175%.

Why is this so?

The regulatory authorities of a country may actively keep their currency weak in order to boost exports; if the currency is weaker, the goods produced domestically for export become cheaper for the rest of the world, and by the simple principle of demand and supply, the demand for its goods increases.

Monetary authorities achieve this using a variety of instruments at their disposal. It can impose foreign exchange controls – artificially restrict the movement of the currency. The central banks also participate in the foreign exchange markets to keep the currency at the desired level. For example, if the rupee begins to appreciate against the dollar, RBI steps in, sells rupees and buy dollars, which will devalue the rupee.

Devaluation is sometimes used deliberately as a policy action in times of contraction, where the country would want to get back to the growth path through exports. However, continued devaluation can be seen as a manipulative path of action which seeks to keep a currency artificially weak and will usually face outrage by the international community. This might also result in a competitive devaluation amongst competitors, which can have grave consequences for global financial stability.

Shobitha Cherian is an intern at Takshashila Institution and studies B.Sc economics at Christ University

Anupam Manur is a policy analyst at Takshashila Institution and tweets @anupammanur

 

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