Currency Volatility and Trade Wars

Abstract

Trade wars, tariffs, quotas and other barriers governments use to protect industries or to retaliate, have become a defining feature of the global economy, and one of their most closely watched side-effects is currency volatility: sharp, uncertain swings in the exchange rate of one currency against others. This paper argues one specific thing. When a trade war moves a currency, the main driver is usually not the change in the two countries' trade balance, but indirect capital flows, investors rushing into safe-haven assets, above all the US dollar, as risk and uncertainty rise. Trade-balance effects are real but second-order. I test this claim against three episodes, the US-China war (2018 to 2020), Turkey's 2018 crisis, and India's rupee sell-offs of 2018 and 2022, and show that the size and even the direction of the currency moves line up with capital flows and the global demand for dollars far better than with bilateral trade. If that is right, the policy response should be built from monetary and capital-account tools, not from tit-for-tat trade retaliation.

1. Introduction

1.1 Understanding trade wars

A trade war is an economic conflict in which countries impose restrictions, tariffs (taxes on imports), quotas (limits on quantities), subsidies, or tough regulatory standards, to shield domestic industries or punish a trading partner. History offers a warning: the Smoot-Hawley Tariff Act of 1930 deepened the Great Depression by choking global trade. The most prominent recent example began in 2018, when the United States placed tariffs on Chinese goods, China retaliated, and the dispute escalated across agriculture, technology and beyond. These measures raise prices for consumers, disrupt supply chains and inject uncertainty into markets, and it is through that last channel, uncertainty, that they reach the currency market.

1.2 Understanding currency volatility

Currency volatility is the degree to which an exchange rate fluctuates over time; economists often measure it with tools such as standard deviation or GARCH models. Many things move exchange rates, inflation, interest rates, GDP growth, elections, policy changes, but investor sentiment is central: when confidence drops, capital moves quickly toward assets seen as safe. A weaker currency makes a country's exports cheaper but its imports (and imported inflation) dearer, and it can trigger capital to flow out. Trade wars matter here precisely because they are uncertainty machines: they give investors a reason to move money, and moving money is what moves currencies.

1.3 The argument

This is where the paper takes a position. The popular story is a trade-balance one: tariffs cut a country's imports, reduce demand for foreign currency, and so shift exchange rates in line with the improving or worsening trade balance. The competing story is a capital-flows one: the dominant force is not goods crossing borders but money seeking safety. When trade tensions flare, investors sell riskier (often emerging-market) assets and buy safe-haven ones, most of all the US dollar, so the currencies that move most are driven by global risk appetite and US monetary policy, not by any single bilateral trade balance.

My claim is that the capital-flows story wins: indirect safe-haven flows explain most trade-war currency volatility, while trade-balance effects are secondary. This is falsifiable. If the trade-balance story were dominant, currency moves should be roughly proportional to the size of the trade shock between the two combatants, and confined to them. If instead we see moves that are wildly out of proportion to the trade shock, or that hit countries in no trade war at all, the capital-flows story is the better explanation. Sections 3.1 to 3.3 apply exactly that test.

2. Two theories of how trade wars move currencies

The trade-balance channel is the textbook intuition, and it is not wrong: tariffs really can alter trade flows and, with them, the demand for a currency. But it struggles to explain magnitudes. A steel tariff worth a few billion dollars cannot, by itself, move a currency 40%.

The capital-flows channel can. Its clearest statement comes from Hélène Rey's "global financial cycle" framework, which shows that capital flows, credit and asset prices across many countries move together, largely in step with US monetary policy and with the VIX, Wall Street's index of fear. Rey's striking conclusion is that "whenever capital is freely mobile, the global financial cycle constrains national monetary policies regardless of the exchange rate regime" (Rey, 2015). In plain terms: when global risk appetite turns, money floods toward the dollar and out of riskier currencies, and it does so almost regardless of what any individual country's trade balance is doing. A trade war is one thing that can turn that risk appetite, which is why its currency effects run mostly through capital, not trade. (The older literature on trade wars, from Irwin's history of US trade policy to the running Bown-Kolb tariff timeline, documents the policies; the question here is the transmission mechanism.)

3. Testing the claim: three case studies

3.1 China (2018 to 2020): the yuan's fall was mostly a dollar story

As US tariffs escalated, the Chinese yuan weakened, sliding past the symbolic 7-per-dollar mark on 5 August 2019, its weakest level since 2008, and Washington immediately branded China a "currency manipulator" (Al Jazeera, 2019). At first glance this looks like a trade-balance move. But look closer. As Econofact pointed out, the dollar at the time was strong "against a wide range of currencies, and not just the yuan," which "points to domestic sources of the dollar's high value, not Chinese actions" (Econofact, 2019). The yuan was not being singled out by trade flows so much as caught in a broad, dollar-wide rise driven by US conditions and safe-haven demand. China is therefore only partial support for either story, but even here, the common driver is the global appetite for dollars, not a clean bilateral-trade effect. (The manipulator label was quietly dropped in January 2020, before the Phase One deal.)

3.2 Turkey (2018): a 40% collapse far too big to be about trade

Turkey is where the trade-balance story breaks. In 2018 the US doubled tariffs on Turkish steel and aluminium amid a political dispute, a genuinely small trade shock. Yet the lira lost "more than 40 percent of its value against the dollar" over the year (Econofact, 2018), a move orders of magnitude larger than the trade flows involved. Econofact's verdict is blunt: the US tariff was only "the match that ignited this economic conflagration," while "the combustible conditions were homemade", heavy foreign-currency corporate debt and inflation near 15.6% (Econofact, 2018; Al Jazeera, 2018). What turned a spark into a fire was capital flight: investors fled Turkish assets, and the currency followed. This is the capital-flows channel in its purest, most destructive form.

3.3 India (2018 and 2022): volatility with no trade war at all, the decisive test

India is the case the popular framing overlooks, and it is the sharpest test of all, because India was not in a trade war driving either of these episodes. If bilateral trade balances explained currency moves, the rupee should have been calm. It was not.

In August 2018, as Turkey's crisis spread, the rupee broke ₹70/$, a roughly 2% one-day drop, and had slid about 9% over the year (The Economics Review, 2018). The transmission was pure sentiment, not trade: the Atlantic Council noted that Turkey's collapse pressured "the Indonesian rupiah, the South African rand, and the Indian rupee," as emerging-market portfolio inflows dried up from "$13.7 billion in July to just $2.2 billion in August" (Atlantic Council, 2018). Money, not merchandise, moved the rupee.

The 2022 episode tells the same story with a different trigger. As the US Federal Reserve raised rates aggressively, the dollar surged and the rupee hit a then-record 77.53/$ on 9 May 2022. The RBI ran down reserves to about $598bn, roughly 7% below their >$640bn September-2021 peak, to slow the fall, explicitly trying to curb excessive volatility rather than "fight the Fed" (The Print, 2022). India's currency was moving with the global dollar cycle, exactly as Rey's framework predicts, and its central bank was reaching for capital-account tools, reserves, not trade policy. Across the emerging world the same pattern held: currencies that had built reserves and raised rates pre-emptively (Brazil from February 2021, then Mexico, Chile and South Africa) weathered 2022 far better, depreciating "only modestly" (Dallas Fed, 2023). The defence against trade-war-era volatility was monetary and financial, because the threat was.

4. What follows for policy

If capital flows, not trade balances, drive the volatility, then trade retaliation is the wrong tool, it fights the symptom while feeding the uncertainty that caused the problem. The response should be built from monetary and capital-account instruments, matched to the mechanism.

1. Rules-based FX intervention, funded by a reserve buffer. Reserves should be used to smooth disorderly moves, not to defend a particular exchange-rate level, precisely the posture the RBI took in 2022, spending reserves to slow the rupee while accepting the trend (The Print, 2022). The 2022 evidence shows this works: emerging markets that had accumulated reserves in advance were markedly more resilient (Dallas Fed, 2023).
2. Targeted, temporary macroprudential and capital-flow measures during risk-off surges. This is Rey's explicit prescription: because the global financial cycle can overwhelm even a floating exchange rate, countries should lean directly against destabilising capital swings and excessive leverage rather than rely on the exchange rate alone (Rey, 2015).
3. Structurally reduce dollar dependence. Because so much of the volatility is dollar demand, cutting reliance on the dollar for trade lowers exposure. India's own July 2022 mechanism for settling international trade in rupees, through Special Rupee Vostro Accounts, is a concrete example of this, designed to let trade proceed without routing every payment through a major reserve currency (India-Briefing, 2022).

Together these amount to the logic behind the IMF's Integrated Policy Framework, using foreign-exchange intervention, macroprudential rules and capital-flow measures jointly rather than trusting any one lever.

4.1 Feasibility and challenges

None of this is free. Aggressive rate hikes stabilise a currency but slow growth and raise borrowing costs. Reserve buffers take years to build, and smaller economies with trade deficits struggle to accumulate them. Capital-flow measures can deter the long-term investment a country needs and must be temporary and well-targeted to avoid signalling panic. And reducing dollar dependence is a slow, structural project, global markets still run on the dollar, so rupee-settlement schemes start small. The realistic answer is a mix, tailored to a country's size, reserves and openness, not a single silver bullet.

4.2 Stakeholders

Managing this volatility falls to several actors. Central banks (the RBI, the Fed, the ECB, the PBOC) set interest rates, manage reserves and intervene in currency markets. Governments shape trade and sanctions policy and negotiate agreements. Businesses and multinationals hedge exchange-rate risk and adjust supply chains and pricing. Investors and financial institutions are, in this account, not bystanders but a primary driver, their flight to safety is the mechanism. International institutions (the IMF, the WTO) mediate disputes and provide frameworks and financing. Consumers absorb the result through import prices and inflation.

5. Conclusion

Trade wars and currency volatility travel together, but not for the reason most often assumed. The trade-balance channel is real yet too small to explain the moves we actually see; the dominant force is indirect capital flows, a flight to the dollar driven by global risk sentiment and US monetary policy. The three cases bear this out: the yuan's fall was largely a broad-dollar phenomenon, the lira's 40% collapse was capital flight far out of proportion to any trade dispute, and India, in no trade war at all, was whipsawed in both 2018 and 2022 by the global dollar cycle. The honest caveat is that these are illustrative episodes, not a formal statistical test, and domestic weaknesses (Turkey's debt, India's current-account deficit) clearly amplified the swings. But the pattern is consistent enough to change the policy question. The right defence against trade-war currency volatility is not a better tariff; it is a better set of monetary, reserve and capital-flow tools, and, over time, a little less of the world's business run in dollars.

Sources

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2. Econofact (2019). Is China Weakening the Yuan to Fight U.S. Tariffs? econofact.org
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5. Atlantic Council (2018). Turkish Outbreak: Risk of Emerging Market Contagion? atlanticcouncil.org
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7. The Print (2022). With US Fed tightening, RBI seen prudent in spending forex reserves to defend rupee. theprint.in
8. Federal Reserve Bank of Dallas (2023). Emerging-market countries insulate themselves from Fed rate hikes. dallasfed.org
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