The Relationship between Exchange Rate and Foreign Trade
The relevance of this work is supported by the fact that rapid development of internationalization and globalization of economic processes is happening in the world, which leads to the currency factor becoming one of the main elements of the global economy. Its role has long gone beyond the foreign trade operations and now the development of processes in the monetary sphere is reflected in all economic relations.
Sudden fluctuations in the exchange rate increase international economic instability, including monetary and financial relations, as well as causing negative social and economic consequences and the loss of some gains in other countries. At the same time, one of the main objects of the impact from the currency factor is still international trade. Annual volumes of world exports continue to increase. New countries “gain weight” in the system of international economic relations, which leads to increased competition and gives new impulses to trade conflicts.
Exchange rates have a significant impact on foreign trade in different countries, affecting price ratios of exports and imports, causing a change in the domestic economic situation, as well as affecting competitiveness of firms and profits of enterprises. Using the exchange rate compares the entrepreneur’s cost of production to world market prices. This makes it possible to reveal results of foreign trade operations of individual companies and the country as a whole (Copeland, 2008).
The aim of this essay is to study the mechanisms of the effect of currency factors on international trade in modern conditions, assessment of the quantitative characteristics of such an effect, and analysis of the basic principles of interaction between the exchange rate and foreign trade during the economic change in the world.
Factors Affecting the Relationship between the Exchange Rate and Foreign Trade
Today, one of the most promising directions of development of international economic relations concerns international monetary relations. They arise due to the use of money in international operations. Most calculations are performed in the form of money and, therefore, there are contradictions regarding the use of certain currencies. Each country has its own currency, which is used in the calculations in its territory, but outside of the given state they become foreign currency. The concept of currency denotes a monetary unit of any country, foreign countries, and international counting currency units.
Currency relations initially arose due to the development of international trade, but over time they have gained independence. This is due to the increasing internationalization of economic life and the development of international integration and specialization, as well as an increase in the number of foreign exchange transactions. There are many national units and they relate to each other in certain proportions. The exchange rate is a relation between two different currencies, which is established under the influence of supply and demand on the market or is determined by the law. The exchange rate is expressed in the currency of another country or the international unit of account. The exchange rate is influenced by many factors. It is based on the purchasing power of the currency. The purchasing power, in turn, determines the average level of prices and investment in the country. However, its value is also affected by inflation and balance of payments. The intervention of the central bank in the foreign exchange market operations can also affect the exchange rate (Kallianiotis, 2013).
The exchange rate may be nominal and real. The nominal exchange rate is a kind of “price” in the exchange of one currency for another, for example, the dollar comparing to the euro. The real exchange rate is obtained by multiplying the nominal exchange rate by the ratio between the price levels in the countries. Besides, the real exchange rate can be calculated on the basis of average prices in countries that are major partners of the country in the field of trade. Thus, the exchange rate will be a kind of measure of the competitiveness of a given country in relation to foreign goods.
The exchange rate has a substantial influence on international economic relations:
1. It helps to predict future financial performance of the economic activity and, therefore, determines the most profitable economic ties. This is due to the fact that producers can compare their costs with world prices;
2. The direct impact is exerted on the socio-economic situation, which is manifested in many other indicators such as balance of payments;
3. There is the effect on the redistribution of the world’s total gross domestic product between countries.
It is for this reason that policy intersects with interests of different countries, which in turn may lead to conflict. In this situation, governments need to take appropriate measures not only at national, but also international levels. These measures should be able to effectively resolve conflicts and disagreements.
Currency exchange has been around for a long time: for centuries this exchange has existed in an undeveloped form, namely the money-changing business. Now, currency exchange is carried out in the currency markets. The volume of daily trade is huge and it cannot be explained only by the needs of international trade and investment flows. An important role is played here by currency speculation. The fact is that many people want to earn money to correctly guess the future movement of the exchange rate. In case of a correct calculation of the profit, it can constitute a significant portion of the money invested, but in case of miscalculation losses will also be considerable (Bergsten and Gagnon, 2012).
The gradual formation of stable relations between countries over the purchase and sale of foreign currency has resulted in each country’s national and later global monetary system. Currency system can be viewed in two ways:
1. It is a law by virtue of the increasing strengthening of international economic relations;
2. It is secured with the help of specially developed standards at the national level and by international agreements.
Any monetary system, as well as other systems consists of a number of elements and relationships between them. The basis of all is the currency. In national systems, this role is performed by the national currency and in the world in general by counting currency units and reserve currencies, which are used as international payment and reserve funds.
The degree of convertibility, which means the level of freedom of exchange of the currency in the foreign market, is an important characteristic. There are freely convertible, partially convertible, and non-convertible currencies. Convertibility is characterized by the absence of currency restrictions, i.e. measures that define and control operations with national currencies. Today, in most countries there are certain limitations and leading currencies of economically developed countries are fully convertible. Full convertibility of any currency can be achieved only through deep structural changes in the economy (Cline, 2013).
All national currencies are exchanged at a certain ratio, which is defined by the law. This ratio is called parity. There are also foreign exchange rates: fixed and freely floating. For a fixed rate, some fluctuations are allowed only in certain cases, while free-floating exchange rate regime is formed by the interaction of supply and demand. Apart from these, there are combinations of different degrees and variations. In addition, the foreign exchange rate of the system includes the foreign exchange market and the gold market.
The Mechanism of the Relationship between Exchange Rate and Foreign Trade
There is a mutual relationship between the dynamics of the exchange rate and individual elements of the balance of payments. Exports of goods and services, foreign investment, and loans from international organizations are all major foreign exchange earnings. They have a positive impact on stability and predictability of the national currency exchange rate. The import of goods and services, the export of capital, the payment of interest payments, and international credit institutions reduce foreign exchange reserves and the possibility of maintaining the national currency rate. The surplus acts as a stabilizing factor in relation to the foreign exchange market (currency stability, growth of gold and currency reserves) and helps to maintain a more liberal rate of foreign exchange restrictions, thereby increasing convertibility of the national currency. In turn, the dynamics of the national currency can significantly affect the state of the country’s foreign trade and consequently the national economy as a whole.
By lowering the rate of the national currency, exporters receive a premium in exchange export proceeds of foreign currency. At the same time, depreciation of the national currency increases the cost of imports, which stimulates growth of prices in the country, reduction of import of goods, and use or development of the national production of goods instead of the imported ones. The decline in the exchange rate reduces the real debt in the national currency, but increases the severity of the external debt denominated in foreign currency. It becomes unprofitable to export profits, interest, and dividends received by foreign investors in the currency of host countries. These profits are reinvested or used to purchase goods at domestic prices for their subsequent export (Ghosh, Gulde, & Wolf, 2003).
With an increase of the national currency (on equal conditions, this means an increase in export prices in foreign currency), domestic prices become less competitive as compared to consumer imports. Besides, the export performance might fail, which could lead to a reduction of exports of the country. The actual amount of foreign debt denominated in foreign currency might be diminished. The influx of foreign investment is stimulated, but export of profits on foreign investments might increase. These relationships reveal the possible impact on foreign trade, attracting investments, external loans, and other forms of international economic relations by adjusting the exchange rate. However, such practice depends on the dynamics of domestic prices in partner countries for foreign economic relations.
The fall of the national currency, on equal conditions, will bring benefit to the exporter only if it grows faster than domestic prices. If the depreciation of the national currency falls short of the growth of domestic prices, the exporter will still be at a loss. In other words, the relationship between external (the nominal exchange rate) and internal (the purchasing power of the currency) values of the national currency is important for the development of international economic relations with other countries. The most general form of the interaction of these variables is as follows: if the pace of domestic inflationary depreciation of money is ahead of the pace of currency devaluation (external devaluation of money), then, other things being equal, the domestic market consumption imports will become more profitable as prices in the foreign currency rise (Bergsten, 2014).
If devaluation is outstripping the growth in domestic prices caused by inflation, then there are the conditions for monetary dumping: mass export of goods at prices below the world average. They are associated with a lag of falling purchasing power of money by lowering their exchange rate. The source of the decline in export prices is the exchange rate differences arising from the exchange proceeds in a more stable foreign currency in case of the depreciation of the national currency. Dumping price may be below the cost of production. The country, which practices currency dumping, experiences increased profits of exporters and the standard of living of citizens is reduced due to the increase in domestic prices. If the pace of price growth in the national economy is ahead of the pace of price growth in partner countries of international relations, the purchasing power parity of the country falls and there is an objective basis for its devaluation.
International flows of goods, finance, and labor are caused by the difference existing between the two countries in national price levels. The condition of the price competitiveness of the national economy is determined by such parameters as the real exchange rate. It depends on the dynamics of the nominal exchange rate and the price dynamics in the country and major trading partners with pricing terms that explore, in other words, the relative rate of inflation and devaluation in the countries compared. Regulation by the change in the nominal exchange rate, which forms an economic point of view, characterizes only conditions for the exchange of national currencies or the conversion factor of one currency to another. The real appreciation of the national currency against the country’s main trading partners reduces the price competitiveness of exports of the country due to the faster growth of domestic prices along with the devaluation of the national currency of the country concerned and the prices of these countries (Klein & Shambaugh, 2010).
Factors Influencing the Exchange Rate Regime
There are a number of criteria related to structural characteristics of the economy, as well as macroeconomic and institutional conditions, which should be considered when choosing optimal conditions for a specific exchange rate regime.
The scale of the economy and its degree of openness. The larger the economy, the stronger arguments in favor of a flexible exchange rate. However, the more open the economy, the less attractive a flexible exchange rate since the higher costs of adaptation to the economy, the higher adjustment of the exchange rate. However, an open economy is more vulnerable to adverse processes in foreign markets and in this case minimization of their negative impact may require a change in the exchange rate. In general, needs of small open economies are more consistent with a fixed exchange rate.
Diversification of production and exports. The more diversified the economy, the more appropriate exchange rate flexibility. Countries with less diversified exports tend to face significant fluctuations in foreign exchange earnings due to fluctuations in supply and demand in foreign markets. This may encourage them to use a fixed exchange rate to avoid additional negative consequences of significant currency fluctuations. However, the greater the fluctuations in supply and demand on the world market, the harder it is to maintain a fixed exchange rate (Thorstensen, Mar?al, & Ferraz, 2012).
The rate of inflation. The greater the difference between the level of inflation in the country and in trade partners, the greater the need for frequent adjustments of the exchange rate to maintain the level of competitiveness of national products on world markets. However, the connection of the exchange rate with the currency of a country with low inflation could become an effective mechanism for “binding” of inflation expectations. Therefore, for a country with very high inflation rates fixed exchange rate can be a disciplining factor in domestic economic policy and can promote confidence in the stabilization program.
Capital mobility. The higher the degree of international capital mobility, the harder it is to maintain a fixed exchange rate regime. Today, the scale of transactions in foreign exchange markets, international stock markets, and capital markets is many times greater than the volume of international trade. Large short-term capital flows are able to quickly destabilize the economy, including the foreign exchange market of any country, thus undermining effectiveness of macroeconomic regulation.
Types of economic shocks. Another approach to the choice of exchange rate regime is based on the assessment of consequences of various destabilizing effects (economic shocks) for the national economy. The best mode, in this case, is the one that stabilizes macro-economic indicators and minimizes fluctuations in manufacturing, real consumption, and the level of prices in the country. It is necessary to distinguish differences between nominal and real economic shocks.
In an open economy with a high degree of capital mobility, floating exchange rate helps to reduce the impact of real economic shocks (such as changes in demand for exports and terms of trade), while fixed exchange rate is desirable when the country is faced with a nominal shock (for example, changes in the demand for money). Thus, if the economy faces a domestic monetary shock, maintaining a fixed exchange rate will be more effective in stabilizing output. Given that the money supply is endogenous under fixed exchange rates, fluctuations in the money market will amortize only change in foreign exchange reserves. It will have no impact on supply and demand conditions in the commodity markets, which determines the level of economic activity. If the economic shock is generated by processes in the real sector, the exchange rate should be adjusted to stabilize the volume of production by creating (or decreasing) a foreign demand. For example, if the domestic demand is increasing, it is advisable to increase the exchange rate to redirect a part of additional demand on foreign markets.
The credibility of the policy within a country. When choosing the exchange rate regime, it is necessary to emphasize the special role of trust and political factors. In case of high inflation in the country, fixing the exchange rate can help to ensure confidence in the stabilization program. In many cases, a fixed exchange rate can play a disciplinary role in the political decision-making, especially in the area of fiscal policy, preventing emission financing the budget deficit. This is especially important for developing countries, which do not have such opportunities to share fiscal and monetary policy as the ones in developed economies (Nicita, 2013).
Thus, on the basis of the conducted research on the topic of the relationship between exchange rate and foreign trade the following conclusions can be made.
The exchange rate is defined as the value of the currency of one country expressed in the currency of another country. The exchange rate is necessary for trade in goods and services, movement of capital and credit, comparison of prices on world commodity markets, as well as value indicators of various countries, and periodic revaluation of foreign currency accounts of companies, banks, governments, and individuals. Exchange rates are divided into two main types: fixed and variable. Fixed exchange rate fluctuates within narrow limits. Floating exchange rates are dependent on market supply and demand for foreign currency and may vary greatly in size.
Changes in the exchange rate have a direct impact on international trade (volume and direction of trade flows) and balance of payments. Formation of the exchange rate affects a number of factors: 1. the rate of inflation; 2. the balance of payments; 3. the difference between interest rates in different countries; 4. activities of foreign exchange markets and speculative currency transactions; 5. the extent to which a particular currency is used in international payments; 6. currency exchange ratios affect or delay the acceleration of international payments; 7. the degree of confidence in the currency on the national and world markets; 8. foreign exchange policy.
The monetary sphere is now a complex web of elements of national and international issues where the important place is occupied by national and international currency regime, status of individual currencies, international institutions coordinating the development of currency relations, forms and methods of regulation of these relations on the scale of one or more countries, and many more.