April 26, 2020
While the focus of most market commentary is on re-opening the economy as the effects of COVID-19 recede, there are many difficulties associated with doing so. One that may not get a lot of attention is the effect of currencies on trade.
Many commodities around the world are traded in $US, including the top 10. Oil (Brent and WTI), Steel, Soyabeans, Iron, Corn, Gold, Copper, Aluminum and Silver result in the massive transfer of money in $US on a daily basis.
When the US dollar rises, that makes these products more expensive to countries that do business in their local currencies. It creates inflation for those economies, and when the US competes with those same countries in other goods, it reduces inflation for the US. In many ways this is a virtuous circle . . . at least until there is stress in the trading relationship, and COVID-19 is causing a lot of stress.
Currently prices for many commodities have collapsed due to the absence of demand, but when economies start to re-open, many buyers will be severely constrained financially at the same time as their local currencies are significantly lower than prior to the crisis.
For example the Brazilian Real has gone from a value of 3.1 Real to buy a USD in early 2018 to almost 6 Reals as of late April. That will make goods about 80% more expensive. This drop will severely curtail Brazil’s ability to import goods. In 2018, Brazil imported a lot of fuel, aircraft and machinery among other things, representing 2.4% of US exports.
In 2018, the European Union represented about 19% of US exports, but that currency is struggling as well. In early 2018, only 0.81 Euros were needed to buy a US dollar, but that has climbed to 0.92, a jump of about 13%. With the massive borrowing required to sustain the economies in Europe hard hit by COVID-19, it is likely that the currency will continue to weaken in the coming months to reflect the growing risks to the economy. It also will make EU exports more palatable, increasing competition for goods.
Trade with China is frequently in the news primarily because of concern over levels of import from China to the US, but in 2018, China represented just 7.2% of US exports. A key focus of the Trump presidency is to force China to import more goods made in the USA. That seems less likely as the Yuan has gone from 6.3 Yuan to the USD to about 7 Yuan to the USD. Again this represents a significant drop of 11%. (sorry no chart for the Yuan).
Smaller countries can fare even worse. The South African Rand has gone from 12 to 1 to 19 to 1, making US products 58% more expensive. The Chilean Peso has gone from 600 to 1 down to a recent 850 to 1 making US goods 42% more expensive.
The end result of this is that many economies are borrowing significant amounts of money in an effort to prevent economic collapse, but this is negatively impacting their currencies and makes it more difficult to purchase products from countries with expensive currencies. Over time, there will be a shift away from the US for many goods.
One of the secrets of the US success is that many of these goods are priced in US dollars. That means that countries around the world hold significant amounts of US dollars as reserve currency, to protect against this sort of devaluation in the local currency and also to make payments for goods that are priced in US dollars.
But there are also efforts underway to change that. China is working with Japan, Russia India, and some middle eastern and African countries to execute bilateral trade in the Yuan. It is still early to understand the scope of this activity or whether China will incur the same trust as the US has but it is clear that there is frustration with the US dollar as a reserve currency. The IMF has also been pushing for a change, including the SDR and digital currencies.
Another objective of the US central bank is to encourage inflation, and an easy way to accomplish this would be to reduce the use of the US dollar as a reserve currency. As appealing as this might seem, this would likely also reduce the attractiveness of US debt and could cause a serious deflationary spiral in US assets while raising prices dramatically. That outcome is not ideal.
It takes a long time to change perceptions of currencies in normal circumstances and even longer to change trade patterns where there are deep operational and contractual obligations. Still the strengthening of the US dollar will make a recovery in trade via export difficult.