The 10% depreciation of the trade-weighted US dollar over the past year is an underappreciated driver of the synchronised upswing in world trade and global economic growth. That’s because movements in the US dollar have global consequences above and beyond movements in any other currency – dollar appreciation tends to crimp global trade and credit flows, while dollar depreciation tends to boost global trade and credit. Whether dollar weakness continues or reverses in 2018 will therefore be a key driver of whether the upswing in global economic growth can continue.
Appreciation and Depreciation – does it really matter globally?
In standard open-economy macroeconomics, currency appreciation raises the cost of a country’s exports in international markets and lowers the cost of its imports in its own currency. With its exports more expensive and its imports cheaper, the country exports less and imports more. This deterioration in the trade balance means less demand for domestically produced goods, lowering domestic economic activity in the country while simultaneously boosting activity in the rest of the world. In this simple setting, the aggregate global impact is neutral.
Similarly, currency depreciation lowers the cost of a country’s exports in international markets while raising the cost of imports in its own currency. Export demand increases and import demand declines. The trade balance improves, as does overall domestic activity in the country, while it simultaneously falls in the rest of the world. Aggregate global activity is unchanged.
The Trade Reaction
The key assumption underlying this logic is that the prices of goods are ‘sticky’ in the currency of the country producing them. Exporters set the price of goods in their own currency and then vary the price when denominated in foreign currencies in line with exchange-rate fluctuations. Hence, in international markets, currency appreciation makes a country’s goods more expensive, and currency depreciation makes a country’s goods less expensive.
The problem with this assumption is that it doesn’t seem to reflect the reality of how international trade actually works. The price of many countries’ exports sold in international markets just don’t seem to move much in response to changes in bilateral exchange rates with trading partners. Indeed, work by the Harvard economist Gita Gopinath suggests that a 1% move in the bilateral exchange rate between two countries moves their bilateral terms of trade (the relative price of their imports and exports) by just 0.1%.
Why the indifference?
The key to unravelling this disconnect is that a large share of international trade is transacted in US dollars, even when the US itself is not party to the transaction, and the prices of goods transacted in US dollars are ‘sticky’ in dollars.
For example, while the US is on one side or the other of around 10% of world trade, the US dollar is used in about 40% of trade transactions. The UK sells nearly 30% of its exports in dollars, despite sending only 15% of them to the US; Japan sells half its exports in dollars, despite sending 22% of them to the US; and Argentina sells a whopping 97% of its exports in dollars, while sending just 8% of them to the US.
The importance of USD – “Uncle Sam the Middle Man”
To understand the significance of this, imagine that China is selling goods to India, and the transaction is invoiced in US dollars. Fluctuations in the rupee-renminbi exchange rate therefore do not impact the price or quantity of goods sold in the way that standard open-economy macroeconomics suggests. Instead, fluctuations in the rupee-dollar exchange rate are what matter: dollar appreciation will raise the cost of Chinese exports to India, no matter what the renminbi is doing, thereby reducing Indian demand for Chinese goods.
The dominant role of the US dollar in international trade invoicing means that dollar appreciation crimps demand not only for US exports but also for all dollar-denominated exports
All this means that world trade volumes are driven in large part by the US dollar exchange rate. The dominant role of the US dollar in international trade invoicing means that dollar appreciation crimps demand not only for US exports but also for all dollar-denominated exports. Dollar appreciation is a headwind for world trade; meanwhile, dollar depreciation is a tailwind for global trade.
This trade-invoicing transmission channel is reinforced by the widespread use of the US dollar as a funding currency for debt issuance and cross-border bank lending. Non-US borrowers (particularly in emerging markets) frequently issue debt and obtain bank loans denominated in dollars – a practice known as ‘original sin’. Dollar appreciation increases the local-currency cost of servicing a given amount of dollar debt, which then means that fewer resources are available for hiring, investment and production. It also increases the probability of default, causing lenders to rein in the amount of dollar lending they are willing to extend and to raise the interest rate on the lending they do still undertake. Higher interest rates mean that financial conditions tighten, further exacerbating the hit to economic activity. Dollar depreciation, on the other hand, has the opposite impact, boosting credit flows and easing financial conditions, all of which should boost global economic growth.
The dominant currency paradigm
This is all encapsulated in the ‘dominant currency paradigm’: trade prices are sticky in dollars, meaning that the value of a country’s currency relative to the dollar is a primary driver of a country’s import prices and quantities regardless of where the goods originates. Gopinath finds that this means a 1% US dollar appreciation against all other currencies leads to a 0.6–0.8% decline within a year in the volume of total trade between countries in the rest of the world.
The 10% trade-weighted depreciation of the US dollar over the past year is therefore likely to have played a significant role in the recent revival of world trade growth – and will continue to feed through into decent trade growth for much of this year, given the lags involved. Further dollar weakness in 2018 would provide another fillip for global economic activity and could make even our upbeat global GDP forecasts look too conservative. On the other hand, renewed dollar strength would point to more caution on the outlook for global growth. Now, if only there was a fool-proof way to forecast currency moves!
The article above was previously published on Aberdeen Asset Management’s ‘Thinking Aloud’ blog on 14th February 2018