The Effect of Currency Valuation on Trade? None!

January 30, 2016

Whenever some senator or congressman wants to appear tough on trade – usually during a campaign for re-election – they call on the president label a country like China or Japan a “currency manipulator.”  They do this because under the rules of the World Trade Organization a country that’s guilty of manipulating its currency can have tariffs levied against it.  Of course, it never happens.

The reasoning is that a nation that takes actions designed to weaken its own currency gives them an unfair trade advantage, making its own domestically-produced products cheaper for its citizens and for foreign buyers while making imports more expensive.  It all sounds perfectly logical.  But is it really valid?

In my recent posts, we found that there is a very powerful relationship between population density and trade imbalances in manufactured products.  Free trade with nations much more densely populated than our own is almost assured to produce a trade deficit, while free trade with nations less densely populated usually results in a trade surplus.  So strong is this relationship that it seems to be the dominant driving force in determining the balance of trade.  However, that then calls into question just how much of a role currency valuations have, if any.

I have done an exhaustive study of the subject, plotting the change in currency valuations for 159 nations vs. the U.S. dollar against the change in America’s trade imbalance with those nations over a ten-year period ending in 2014.  What I have found is that there is absolutely no correlation between the two whatsoever.

If there were some correlation, what we should see is that a strengthening of a nation’s currency vs. the dollar should yield an improvement in our balance of trade with that nation, since our exports become more affordable to the people of that nation while their exports are more expensive for our citizens.

Here’s what actually happened.  During the ten-year period from 2005 to 2014, the currencies of 80 nations rose vs. the dollar.  The currencies of 67 nations fell vs. the dollar.  And the currencies of 12 nations remained unchanged against the dollar.  Of the 80 nations whose currencies rose vs. the dollar, our trade imbalance improved with 44 of them.  That shows that the currency valuation theory is valid?  Not so fast.  Of the 67 nations whose currencies weakened vs. the dollar, our trade imbalance worsened with only 16 of them.  Add these together and our trade imbalance changed as the currency theory would have predicted with only 60 of the 147 nations, or 41% of the time.  (With the twelve nations where their currencies were unchanged, our trade imbalance improved with ten of them.)

In fact, if we plot the data for these 159 nations on a scatter chart, here’s what we see:  Currency Valuation vs. Balance of Trade2.  On a scatter chart such as this, if there is a correlation between the two variables – change in currency valuation vs. change in trade imbalance – the data points would tend to fall along a line.  As you can see, they don’t – not at all.  When I had Excel calculated a trend line with a “determination coefficient,” the coefficient (“R-squared”) came out to 0.002.  A perfect correlation would yield a coefficient of 1.0 and the data points would fall into a perfectly straight line.  Here, the coefficient is about as close to zero as you can get, meaning no correlation whatsoever.

Let’s take a closer look at our ten largest trade partners in 2014 and see how their currencies and our trade imbalances have fared over the past ten years.  Check this table:  Currency Valuation vs. Balance of Trade.  These ten nations accounted for nearly 73% of all U.S. trade in manufactured goods in 2014.  Their currencies increased in value vs. the dollar for seven of them, and fell for the other three.  But of these ten, our balance of trade changed as currency valuation would predict in only four cases.

Look at China.  In spite of the yuan appreciating in value vs. the dollar by 33%, our trade imbalance actually worsened by 82%.  Look at France and Germany.  In spite of the Euro rising by 12%, our balance of trade with these two nations worsened by 56% and 97% respectively.  (By the way, the next time you hear someone say that America needs to improve its productivity in order to be more competitive, ask them to explain why it is that the U.S. has a large trade deficit with France, arguably the least productive nation in the developed world.)

For anyone who bothers to actually study the matter, the real world data on currency valuation and trade imbalances proves beyond a shadow of a doubt that there is absolutely no correlation between the two.  It’s disparities in population densities that drives trade imbalances and currency valuation has nothing to do with it.

Foreign Investors Abandoning The U.S.

July 19, 2008

Foreign investors are beginning to see the U.S. as a bad place to invest their money.  Their stock investments are losing money.  They’re getting killed by their investments in our mortgage-backed securities.  Their investments in corporate and government bonds are beginning to look risky.  Now they’re looking to Asia.  This is very bad news.

What this means is that interest rates are going to rise.  How far and fast remains to be seen.  Why?  Because the dollars that we send them in payment for imported goods can only be used in one place – the United States.  So their choice is either to sit on those dollars and wait for the promise of higher returns in the future in the U.S., or go ahead and just keep blindly plowing them back into U.S. stocks and bonds and securities.   

At the same time, the U.S. has got to maintain a cash flow balance to finance to the budget deficit and the trade deficit.  It has to issue bonds and sell them to someone.  That someone isn’t Americans.  There is no money left here.  It has to sell them to foreigners holding those dollars.  So, when the Fed holds a bond auction, if no one bids on the bonds at the rate being offered, the rate immediately and automatically is raised.  This will continue until the rate looks attractive enough to offset the perceived growing risk of owning these U.S. investments.  So look for bond yields to begin rising dramatically.  And it’s bond yields that determine interest rates in the U.S. economy, not the Fed’s official overnight funds rate that gets all of the attention. 

Won’t rising interest rates tend to slow an economy that’s already on the brink of recession?  You bet!  Could this turn into a downward spiral?  Right again!  The only way to escape such a spiral is to cut off the root cause by stopping the outward flow of dollars; that is, by eliminating the trade deficit.  And if we wait for currency valuations to do the job, we’ll be waiting forever, and we have very little time to act.  It’s time to walk away from the World Trade Organization and return to the trade policies of tariffs and trade surpluses that once built this nation into an economic powerhouse.

The Start of a New Asian Financial Crisis?

May 29, 2008

One of my predictions for 2008 regarding the global economy was that another currency devaluation war would erupt in Asia, as intensifying competition for the export markets of Europe and the U.S. leads Asian nations to turn to currency devaluation to gain an upper hand on their Asian rivals.  This wasn’t on anyone’s radar back in November of last year but, with an understanding of what a high population density does to per capita consumption, it seemed clear to me that this would be inevitable as Asian nations became ever more dependent on exports to sustain their bloated work forces.  Now it appears to be starting:

… Some observers are even pointing to a potential currency crisis, given Vietnam’s growing current account deficit, weakening fiscal position and limited foreign exchange reserves, on top of 25 percent annual inflation, the second-worst in Asia.

Some of Asia’s largest economies are also grappling with the same risks. Although none look as vulnerable as Vietnam, some are set for their sternest test since the Asian financial crisis of 1997.

The article goes on to blame the price of oil for increasing trade deficits in Vietnam, the Philipines and other Asian nations.  But another way of looking at their trade deficits is to focus not on their imports of oil but on their exports – their inability to sustain exports at a high enough level to fund their oil purchases.  By the way, why is that a trade deficit is a bad thing for every economy in the world except the U.S.?  When the U.S. complains of its trade deficit, Asian nations are the first to deride us for not seeing the imaginary benefits of free trade with them and to admonish us for any thoughts of a return to protectionist tariffs.

This is something that bears watching.  Currency devaluation among Asian nations would be proof positive that we can’t rely on currency valuation as a means of reversing a trade deficit that is rooted in a gross discrepancy in population density between the U.S. and these nations, and has nothing whatsoever to do with currency evaluation.  I’ll keep you posted with further developments on this.