We often hear that a large trade surplus puts upward pressure on a country’s currency (see here for China, for example). A country’s trade balance with another country can indeed provide an indication of trends in the appreciation or depreciation of its currency. But what is the underlying link? The main link is in fact based on the relationship between the trade balance and demand for foreign currency on the foreign exchange market.
The trade balance represents the difference between a country’s exports and imports. When a European exporter (in the eurozone) sells its products to foreigners, it generally asks to be paid in euros. Thus, foreign importers who wish to purchase European products must first obtain euros on the foreign exchange market [1]. With this link in mind, we can establish a relationship between a country’s export volume and the demand for euros: the more Europeans (in the eurozone) export, the greater the demand for euros. Europeans, for their part, will demand foreign currency to import foreign products (the same reasoning applies). They will offer their euros in exchange for foreign currency. While this may seem abstract, it is what implicitly happens when you buy a foreign product. If you buy a computer from an American brand, for example, there is a good chance that it was invoiced in dollars to the company from which you are buying it. The company will therefore have requested dollars and offered euros in return to buy this computer from the American company. Ultimately, importing the American computer will have generated a supply of euros in exchange for dollars. It is therefore easy to see the relationship between the trade balance and the value of a currency: the greater the eurozone’s exports relative to its imports, the greater the demand for euros relative to its supply. And when demand for euros exceeds supply, the price of the euro rises: the euro appreciates.
This basic reasoning helps us understand the theoretical link between a country’s trade balance and the pressures for currency appreciation/depreciation. In practice, this may appear in long-term data in some cases. However, it is rare for the data to appear consistent with this reasoning. And for good reason: the trade balance is far from being the only factor behind the supply and demand for foreign currency. Financial motives, central bank interventions, and structural factors often have a much greater impact on the supply and demand for a currency on the foreign exchange market. This means that the link between the trade balance and the exchange rate is very often not directly observable, even though it is theoretically relevant (economists can see it using econometric analysis).
Notes:
[1] Some large companies request payment in dollars (Airbus, for example, for some of its aircraft sales). Ultimately, however, these dollars will be exchanged for euros in order to pay employees in the eurozone, taxes, and other expenses. Of course, Airbus will certainly keep some of the dollars for its cash flow or to pay foreign suppliers. But in the end, whether an American company asks for euros to pay Airbus, which then exchanges a small portion of those euros into dollars for its cash flow and other purposes, or whether the American company pays Airbus in dollars, which then exchanges a large portion of those dollars into euros to pay its employees and taxes, the result is the same: there is the same demand for euros on the foreign exchange market in both cases. The fact that some exporters are paid in dollars therefore does not change the core relationship between the trade balance and the exchange rate.
On similar topics:
« Decline in emerging countries’ foreign exchange reserves and fears of tighter financial conditions,« article by Mahmoud Harb on BSi Economics
« Risks associated with a depreciation of the yuan,« article by BSi Economics
« BSi map: changes in foreign exchange reserves,« map by Victor Lequillerier for BSi Economics
Julien P.
