top of page

Currency Volatility and Trade Wars

Tanvi Vikash - National Public School, Bangalore

ABSTRACT


Trade wars have become a prominent feature of the global economic landscape in recent years, with high-profile conflicts like the U.S.-China trade war capturing headlines and affecting economies worldwide. These economic confrontations involve the imposition of tariffs, quotas, and other trade barriers, which can disrupt international trade and create significant uncertainty. One of the critical consequences of trade wars is their impact on currency volatility, which refers to the fluctuations in the exchange rate of a currency against others. Currency volatility is a crucial aspect of financial markets, influencing international trade, investment, and economic stability. Various factors contribute to currency fluctuations, including economic indicators, political events, and investor sentiment. However, trade wars introduce an additional layer of complexity and uncertainty, as they can directly and indirectly affect currency values through changes in trade balances and shifts in investor confidence. This white paper aims to explore the intricate relationship between trade wars and currency volatility. We will begin by providing a comprehensive understanding of trade wars, including their historical context and the instruments used. Next, we will delve into the concept of currency volatility, examining its causes and impacts on economies. The core of our analysis will focus on the mechanisms through which trade wars lead to currency fluctuations, supported by empirical evidence and case studies. Finally, we will discuss the policy implications of these dynamics and propose mitigation strategies for governments, central banks, and businesses. By understanding the interplay between trade wars and currency volatility, stakeholders can better prepare for and navigate the challenges posed by these economic conflicts.



  1. INTRODUCTION 


1.1 Understanding Trade Wars

Trade wars are economic conflicts where countries impose trade restrictions, such as tariffs, quotas, or subsidies, to protect domestic industries or retaliate against perceived unfair trade practices. Historically, trade wars have been significant, with notable examples including the Smoot-Hawley Tariff Act of 1930, which exacerbated the Great Depression. In recent years, trade wars have become more frequent, with the U.S.-China trade war starting in 2018 being one of the most prominent. This conflict began with the U.S. imposing tariffs on Chinese goods, leading to retaliatory measures from China, escalating into a broader economic standoff. The instruments of trade wars include tariffs, which are taxes on imported goods, increasing their cost and making domestic products more competitive. Quotas limit the quantity of goods that can be imported, while subsidies provide financial support to domestic industries, allowing them to offer lower prices. Non-tariff barriers, such as stringent regulations or standards, can also be used to restrict imports. These measures can lead to higher prices for consumers, disrupt global supply chains, and cause economic uncertainty. The U.S.-China trade war, for instance, affected industries ranging from agriculture to technology, with ripple effects felt worldwide. Understanding the dynamics of trade wars is crucial for analyzing their impact on currency volatility. By examining the motives behind these conflicts and the tools used, we can better understand how they disrupt international trade and influence economic policies, ultimately affecting currency markets.


1.2 Understanding Currency Volatility 

Currency volatility refers to the fluctuations in the exchange rate of a currency against others over a period. It is a critical aspect of financial markets, as it affects international trade, investment, and economic stability. Volatility can be measured using statistical tools like standard deviation or more advanced models like the GARCH (Generalized Autoregressive Conditional Heteroskedasticity) model. Several factors contribute to currency volatility, including economic indicators such as inflation rates, interest rates, and GDP growth. Political events, such as elections or policy changes, can also lead to significant fluctuations. Investor sentiment plays a crucial role, as shifts in confidence can drive rapid changes in currency values. For instance, a country experiencing economic turmoil may see its currency depreciate rapidly as investors seek safer assets. The impact of currency volatility on economies is multifaceted. High volatility can lead to inflation if the local currency depreciates, making imports more expensive. It can also affect trade balances, as a weaker currency makes exports cheaper and more competitive, but imports more costly. Investment flows are another area affected, as investors may move capital in and out of a country based on currency stability, influencing economic growth.

Understanding currency volatility is essential for analyzing how trade wars can exacerbate these fluctuations, as they introduce additional uncertainty into the economic landscape.



 1.3 Objectives

The objective of this white paper is to provide a comprehensive analysis of the impact of trade wars on currency volatility. We will explore the direct and indirect mechanisms through which trade wars influence exchange rates, supported by empirical evidence and case studies. Additionally, we will discuss the policy implications of these dynamics and propose strategies for mitigating currency volatility during trade wars. By offering insights into these complex relationships, this paper aims to equip stakeholders with the knowledge needed to navigate the challenges posed by trade conflicts in the global economy.



2)LITERATURE REVIEW

2.1 Existing Research on Topic 

The relationship between trade wars and currency volatility has been extensively studied in economic literature, providing a rich foundation for understanding this complex interplay. Douglas Irwin's seminal work, "Clashing over Commerce: A History of US Trade Policy" 2017, delves into the historical context of trade wars, notably the Smoot-Hawley Tariff Act of 1930. Irwin's analysis underscores the detrimental effects of protectionist policies on global trade and economic stability, setting a precedent for understanding the broader impacts of trade conflicts. More recent research has focused on contemporary trade wars, particularly the U.S.-China trade war. Chad P. Bown and Melina Kolb's "Trump's Trade War Timeline: An Up-to-Date Guide" 2020 provides a detailed account of the events and policies that shaped this conflict. Their work highlights the escalation of tariffs and the subsequent impact on trade flows, which in turn affected currency markets. The study by Bown and Kolb serves as a valuable resource for understanding the direct and indirect effects of trade policies on currency volatility.


2.2  Different Perspectives or Debates 

There are varying perspectives within the academic community on the mechanisms through which trade wars influence currency volatility. Paul Krugman 2019 argues that trade wars primarily affect currency values through changes in trade balances and shifts in investor confidence. According to Krugman, when a country imposes tariffs, it can lead to a trade surplus, strengthening the currency, while retaliatory tariffs can result in a trade deficit, weakening the currency. This perspective emphasizes the direct economic impacts of trade policies. In contrast, Barry Eichengreen 2020 focuses on the role of capital flows and safe-haven currencies. Eichengreen's research suggests that the uncertainty created by trade wars can lead investors to move capital to safer assets, causing currency depreciation in the affected countries. This indirect effect is particularly relevant in understanding how trade wars can lead to heightened currency volatility. The debate between these perspectives highlights the multifaceted nature of the issue and the need for a comprehensive approach to understanding the dynamics at play.


2.3 Key Facts, Statistics and Expert Opinions 

Empirical data from the U.S.-China trade war provides concrete evidence of the impact on currency volatility. According to data from the Federal Reserve Bank of St. Louis, the Chinese yuan experienced significant fluctuations during periods of heightened trade tensions. For instance, between 2018 and 2019, the yuan depreciated by over 8% against the U.S. dollar, reflecting the direct impact of trade policies on currency values. Similarly, the U.S. dollar saw increased volatility during this period, influenced by changes in trade balances and investor sentiment. Expert opinions further enrich the understanding of this issue. Olivier Blanchard 2019 emphasizes the importance of considering both direct and indirect effects of trade wars on currency markets. Blanchard's analysis suggests that while trade balances play a crucial role, the broader economic uncertainty and shifts in investor confidence can lead to significant currency fluctuations. This perspective is supported by other economists, such as Maurice Obstfeld 2019, who argues that trade wars can disrupt global supply chains, further exacerbating currency volatility. Additional research by Gita Gopinath and Jeremy Stein 2020 explores the role of multinational corporations in managing currency risks during trade wars. Their study highlights the importance of hedging strategies and the impact of trade policies on corporate decision-making. This research underscores the broader implications of trade wars on businesses and their strategies for mitigating currency volatility. In summary, the existing literature provides a comprehensive framework for understanding the impact of trade wars on currency volatility. Historical analyses, contemporary case studies, and expert opinions collectively highlight the direct and indirect mechanisms through which trade conflicts affect exchange rates. These insights form the basis for our subsequent analysis and discussion, helping to inform policy recommendations and strategies for managing currency volatility during trade wars.

3 ANALYSIS AND DISCUSSION 

3.1 In depth exploration of the topic

Tariffs can be used by government policymakers to protect domestic industries from competition and correct trade imbalances, but they also influence exchange rates and currencies in ways that affect business profits and investment decisions. For example, if adding or raising tariffs  reduces imports from a particular country, it can cause that country's currency to be devalued as demand for its currency declines. However, the relationship between currencies and exchange rates is complex and outcomes of changes to tariffs may vary depending on a variety of factors, including trade balances, foreign exchange markets and investor sentiment. Tariffs influence exchange rates by altering trade flows and affecting the demand for currencies. Tariffs can favor a stronger domestic currency by reducing imports and improving the trade balance. A positive trade balance increases the demand for the domestic currency in international markets. Here's how it works: When a country imposes tariffs on imports, it often reduces the volume of goods coming into the country. This can decrease the demand for foreign currency. This is because fewer imports mean fewer payments to foreign suppliers. In turn, this reduced demand can lead to a stronger domestic currency relative to the foreign currency. For example, if the United States imposes high tariffs on goods from China, U.S. businesses may purchase fewer goods from China. Consequently, there will be less demand for China's currency, potentially weakening it when compared with the U.S. dollar. However, retaliation by China, such as imposing tariffs on U.S. exports, could create counterbalancing effects. Tariffs can carry risks, including economic slowdowns, higher inflation and reduced foreign investment. These may weaken the domestic currency. So, if tariffs disrupt global supply chains, businesses may face higher costs, leading to reduced economic output and less investor confidence in the domestic currency. Consider a real-world example: During the U.S.-China trade war, the imposition of tariffs led to fluctuations in both the U.S. dollar and the Chinese yuan. While the tariffs aimed to protect domestic industries, they also created uncertainty in global markets, leading to currency volatility. Other factors, such as central bank policies and market sentiment, also play a role in determining exchange rates. All things considered, the relationship between tariffs and exchange rates is complex and multifaceted.


3.2 Case Studies 

The U.S.-China trade war (2018-2020) led to significant currency volatility, primarily affecting the Chinese Yuan  and the U.S. Dollar. As the U.S. imposed tariffs on Chinese goods, the Yuan depreciated, crossing the key threshold of 7.0 per USD in August 2019, its weakest level in over a decade. This devaluation partially offset the tariff impact by making Chinese exports cheaper, but it also increased import costs and inflation in China. In response, the U.S. labeled China a “currency manipulator,” escalating tensions further. Meanwhile, the U.S. Dollar strengthened as investors sought it as a safe-haven asset, making U.S. exports less competitive. The People’s Bank of China (PBOC)intervened with monetary policies to stabilize the Yuan, while the U.S. Federal Reserve cut interest rates in 2019 to counteract economic slowdowns caused by trade uncertainties. Following the Phase One Trade Deal in January 2020, the Yuan recovered slightly, but long-term U.S.-China economic tensions continue to influence currency fluctuations.



The U.S.-Europe trade war led to significant currency volatility, particularly affecting the Euro and the U.S. Dollar . Tensions escalated when the U.S. imposed tariffs on European steel and aluminum in 2018, followed by levies on EU goods like wine, cheese, and aircraft parts due to the Airbus-Boeing subsidy dispute. In response, the European Union retaliated with tariffs on American products, increasing economic uncertainty. The Euro weakened against the Dollar, as concerns over trade restrictions and slower European growth caused investors to shift toward USD as a safe-haven asset. The stronger Dollar made U.S. exports more expensive, negatively impacting American manufacturers. The European Central Bank (ECB) responded with monetary easing policies, including lower interest rates and bond-buying programs, to support the Eurozone economy. Currency fluctuations persisted as trade tensions evolved, with both sides threatening further tariffs, particularly in the automobile sector, which could have severely impacted Germany’s economy. Although negotiations in 2020 eased some tensions, unresolved disputes over tariffs and trade imbalances continue to influence EUR/USD movements, reflecting broader economic and political uncertainties between the U.S. and Europe.


The Turkish Lira experienced severe volatility during the U.S.-Turkey trade dispute in 2018, when the U.S. imposed tariffs on Turkish steel and aluminum and enacted economic sanctions over political tensions. These measures, combined with existing economic weaknesses in Turkey, triggered a currency crisis, leading to the Lira losing over 40% of its value against the U.S. Dollar in August 2018. The sharp depreciation caused inflation to surge, increasing the cost of imports and weakening investor confidence. In response, the Turkish central bank raised interest rates significantly to curb inflation and stabilize the currency, while the government sought alternative trade alliances to reduce reliance on the U.S. Although the Lira partially recovered after policy interventions, ongoing geopolitical tensions and trade uncertainties have continued to make the Turkish Lira highly volatile in global markets.


3.3) Comparative Analysis of Different Approaches to Currency Volatility in Trade Wars


Currency volatility during trade wars can be managed through various monetary policies, government interventions, and market-driven strategies. Different countries adopt distinct approaches based on their economic structure, trade dependencies, and geopolitical positioning. Below is a comparative analysis of key strategies used by different nations in response to trade war-induced currency fluctuations.


1. Fixed vs. Floating Exchange Rate Strategies

Different countries handle currency fluctuations during trade wars in various ways. China follows a managed exchange rate, allowing its central bank to weaken the Yuan to make exports cheaper and offset U.S. tariffs, though this led to accusations of currency manipulation. In contrast, the U.S. Dollar operates on a floating exchange rate, meaning its value is determined by market forces. During trade wars, the Dollar strengthened as investors sought it as a safe-haven asset, making U.S. exports more expensive and hurting American manufacturers. Meanwhile, the European Central Bank cut interest rates to stabilize the Euro, while Turkey raised rates sharply to protect the Lira from crashing under U.S. sanctions. Brazil’s currency strengthened as it gained from China’s reduced U.S. soybean imports, while Russia redirected oil exports to China and India, helping the Ruble recover despite sanctions. Each approach had its benefits and risks—China’s intervention boosted trade but worsened relations with the U.S., while the U.S.’s free-market system strengthened the Dollar but hurt exports. Ultimately, currency strategies depend on economic policies, trade dependencies, and geopolitical conditions.


2. Monetary Policy Adjustments

During trade wars, different countries adjust their monetary policies to manage currency fluctuations. The European Central Bank responded to U.S.-EU trade tensions by cutting interest rates and implementing bond-buying programs, making borrowing cheaper and encouraging investment to stabilize the Euro . In contrast, Turkey faced U.S. sanctions that caused a sharp decline in the Turkish Lira , leading its central bank to raise interest rates aggressively to control inflation and prevent further depreciation. While the EU’s gradual easing approach helped maintain long-term currency stability, Turkey’s high-interest strategy provided temporary relief but also slowed economic growth. These contrasting approaches highlight how different nations balance economic stability, inflation control, and investor confidence in response to trade-related currency pressures.


3. Trade Diversification to Reduce Currency Risks

During trade wars, countries often diversify trade partnerships to stabilize their economies and reduce currency volatility. Brazil benefited from the U.S.-China trade war, as China, facing tariffs on American soybeans, increased imports from Brazil, strengthening the Brazilian Real in the short term. However, Brazil’s dependence on commodity exports made its currency vulnerable to price fluctuations. Meanwhile, Russia faced severe Western sanctions following the Ukraine war, leading to a sharp Ruble depreciation initially. To counter this, Russia redirected oil and gas exports to China and India, which helped the Ruble recover despite ongoing economic restrictions. While Brazil’s approach relied on temporary trade shifts, Russia’s energy-driven strategy sustained its currency, though long-term isolation remains a risk. These cases show how trade diversification can help stabilize currencies but also expose economies to new vulnerabilities.


4) PROPOSED SOLUTIONS AND RECOMMENDATIONS

4.1) Proper Strategies to Address the Problem 

Building strong foreign exchange reserves, like China and Russia, can cushion economies against currency depreciation and external shocks. Regional trade agreements also help reduce dependency on volatile markets. Moreover, promoting local currency trade settlements and digital currencies can decrease reliance on the U.S. Dollar, which often strengthens in trade wars, making imports more expensive. Lastly, currency hedging tools, such as forward contracts and options, can help businesses manage exchange rate risks. By combining these strategies, countries can reduce economic instability and maintain financial resilience during trade disputes.

4.2) Feasibility and Potential Challenges

Implementing strategies to manage currency fluctuations during trade wars is feasible, but several challenges may arise. Monetary policy adjustments, such as raising interest rates, can help stabilize a currency, but they may slow economic growth and increase borrowing costs, making them difficult to sustain. Trade diversification is another effective approach, but shifting export markets requires time, infrastructure, and new trade agreements, which may not be immediately viable. Building foreign exchange reserves can help protect against currency depreciation, but smaller economies may struggle to accumulate reserves due to trade deficits. Regional trade agreements can provide economic stability, yet political disagreements and regulatory barriers often make them challenging to implement. Reducing reliance on the U.S. Dollar through local currency trade settlements or digital currencies (CBDCs) is promising, but global financial markets still depend heavily on the dollar, making a shift difficult. Additionally, while currency hedging tools can protect businesses from volatility, they require financial expertise and access to stable capital markets. Despite these challenges, a balanced mix of these strategies, tailored to a country’s economic strengths, can help mitigate currency risks and maintain financial stability during trade wars.

4.3 Stakeholders Involved and Their Roles 

Managing currency volatility during trade wars involves multiple stakeholders with distinct roles.

Governments and Policymakers – National governments play a crucial role in shaping trade policies, tariffs, and economic strategies to mitigate currency volatility. They negotiate trade agreements, impose or remove sanctions, and coordinate with international financial institutions to stabilize economies.

Central Banks – Institutions like the Federal Reserve (U.S.), European Central Bank (ECB), and People’s Bank of China (PBOC) regulate monetary policy by adjusting interest rates, managing foreign exchange reserves, and intervening in currency markets to stabilize exchange rates.

Businesses and Multinational Corporations – Exporters, importers, and global companies are directly impacted by currency fluctuations. They adjust pricing strategies, relocate supply chains, or use hedging tools to minimize financial risks caused by volatile exchange rates.

Investors and Financial Institutions – Banks, hedge funds, and institutional investors monitor currency markets, engage in foreign exchange (Forex) trading, and provide hedging solutions to businesses affected by trade war-induced currency instability.

International Trade Organizations – Entities like the World Trade Organization (WTO) and International Monetary Fund (IMF) help mediate trade disputes, provide financial aid, and support global economic stability during trade-related currency fluctuations.

Consumers – As currency volatility affects import prices, inflation, and employment, consumers face higher costs for goods and services, influencing their purchasing power and economic behavior.


5) CONCLUSION

5.1) Summary of Key Arguments

Trade wars cause currency volatility, affecting global economies in various ways. Countries respond with different strategies, such as monetary policy adjustments, trade diversification, and foreign exchange interventions. For example, China allows the Yuan to weaken to offset tariffs, while the U.S. Dollar strengthens as a safe-haven asset, making exports more expensive. Other nations, like Turkey and Russia, use interest rate hikes and trade shifts to stabilize their currencies. However, these strategies come with challenges, including economic slowdowns, reliance on limited trade partners, and global financial dependencies. Key stakeholders, such as governments, central banks, businesses, investors, and global organizations, play critical roles in managing these fluctuations through policy coordination, financial tools, and trade agreements. Ultimately, a mix of strategic interventions is necessary to mitigate risks, ensure financial stability, and protect economies from long-term disruptions caused by trade wars.


5.2) Final Thought on Topic 

Currency volatility during trade wars is an unavoidable challenge that requires strategic economic policies, global cooperation, and adaptive financial measures. While nations may attempt to manipulate exchange rates, adjust interest rates, or diversify trade partnerships, each approach has risks and long-term consequences. No single solution fits all economies, but a balanced combination of monetary policies, trade diversification, and financial market stability can help mitigate the impact. As global trade continues to evolve, collaboration between governments, central banks, businesses, and international institutions will be crucial in ensuring economic resilience and minimizing financial disruptions caused by trade-related currency fluctuations.


5.3 Implications for Future Research or Policies

Future research should focus on developing more effective monetary policies that can balance currency stability and economic growth during trade wars. Comparative studies on how different economies handle trade-induced currency fluctuations could provide insights into best practices for exchange rate management. Additionally, research on alternative trade settlement mechanisms, such as central bank digital currencies (CBDCs) and local currency trade agreements, could help reduce reliance on major reserve currencies like the U.S. Dollar, minimizing trade war disruptions. From a policy perspective, governments and international organizations should work toward strengthening regional trade agreements to create more resilient economic partnerships. Policymakers should also explore early warning systems and risk assessment tools to detect potential currency instability and take proactive measures. Moreover, global financial institutions like the IMF and WTO could develop new frameworks for currency intervention guidelines to prevent unfair manipulation and ensure market stability. Ultimately, integrating economic resilience strategies into trade policies will be crucial for minimizing the negative effects of trade wars on global financial stability, fostering a more predictable and sustainable economic environment.


REFERENCES

  1. https://www.sciencedirect.com/science/article/abs/pii/S0148296323005155

  2. https://www.investopedia.com/articles/forex/080613/effects-currency-fluctuations-economy.asp

  3. Dynamic exchange rate dependences: The effect of the US-China trade war

  4. The US-China trade war and the volatility linkages between energy and agricultural commodities

  5. How U.S. Tariffs Impact Trade and CurrencyXE.comhttps://www.xe.com › Blog › Currency News

  6. Turkey says U.S. waging 'economic war', lira weakensReutershttps://www.reuters.com › article › business › turkey-sa…

  7. Monetary Policy Meaning, Types, and ToolsInvestopediahttps://www.investopedia.com › ... › Federal Reserve








 


bottom of page