Navigating Foreign Currency Markets in a Trade War

FX Review

Navigating Foreign Currency Markets in a Trade War

International trade skirmishes look set to be the defining economic issue of our time. The foreign currency market has, and is expected to continue to, react strongly to emerging news on the topic. Companies with foreign currency exposure should therefore brace for volatility and investigate the potential benefits of risk management.

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Trade War Risks are Escalating Worldwide

The current trade hostilities between the U.S. and China are the worst since the 1930s and there is an ever-present threat of escalation. At the same time, the U.S. has taken aim at Mexico recently over the surge in migrants seeking to enter the U.S. through the southern border and is mobilizing import tariffs as a threat. Meanwhile, India’s access to the U.S. generalized system of preferences has been rescinded recently, prompting belated retaliation to the imposition of U.S. tariffs on India steel and aluminum. A variety of auto exporters – including Canada, Mexico, the European Union, Japan and South Korea – could face demands for policy concessions if they wish to avoid new trade restrictions.

Higher Tariffs on US Imports are likely to Strengthen the U.S. Dollar

Higher import tariffs raise the cost of imports in a similar fashion to currency depreciation. For example, if the foreign exchange market is in equilibrium before the imposition of a tariff by the U.S., then the automatic response to the tariff will be an offsetting appreciation of the U.S. dollar, though never on a one-to-one basis. This is precisely what happened to the Chinese renminbi/U.S. dollar exchange rate following the announcement on May 9 of an increase in tariffs on approximately US$250 billion in U.S. imports from China. A similar outcome for the Mexican peso/U.S. dollar exchange rate occurred at the end of May when the U.S. announced an escalating tariff on imports from Mexico. The peso then returned to its previous level once the immediate threat was removed. A further depreciation of the renminbi against the U.S. dollar occurred at the beginning of August when the Trump Administration followed through on its threat to impose tariffs on the approximately US$300 billion in imports that had previously been exempt.


Tariff increases - and the threat of tariff increases - can be unpredictable. It is possible that rhetoric will not lead to action and that less adversarial positions will prevail. On the flip side, even when tariff increases are anticipated, the scale of any increase - and therefore its impact on exchange rates - is often uncertain. These factors can make managing currency exposures extremely challenging - but not impossible.

Assessing the Impact of Tariffs on FX Rates

To accurately assess the impact of tariffs on FX rates, consideration needs to be given to:

a) The possibility of retaliation by the country suffering the tariff increase;
b) The duration of the tariff increase;
c) The longer-term response in terms of production shifts to other countries and:
d) Contagion to other currencies.

The last point is especially important and often underappreciated. In an increasingly interconnected world, a depreciation of the renminbi can feed through into compensating moves in other currencies. This was evident with the renminbi’s depreciation at the beginning of August, which fed through into similar moves in a broad range of currencies, including currencies as varied at the Taiwan dollar, the Mexican peso, the Russian rouble and the South African rand. The consequence of this is that even if a company has no direct exposure to the Chinese renminbi, it can still be impacted if it has exposure to the long list of currencies that will respond to moves in the renminbi.

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Varying Retaliation Strategies Further Complicate the FX Outlook

The imbalance in bilateral trade between the U.S. and China – a deficit of US$396 billion in the twelve months to July (according to U.S. data from the U.S. Census Bureau) - means that China cannot retaliate by imposing a similar tariff increase on a similar level of imports. Of course, it has raised tariffs on imports from the U.S., matching the timing if not the size of the U.S. tariff increases. Of course, based on the logic of the link between tariffs and exchange rates, the tariff retaliation by China serves to moderate the depreciation of the renminbi/appreciation of the dollar triggered by the U.S. tariff increases.

However, retaliation can take other forms, including a simple ban on any purchases of U.S. grains - which has occurred already - or a restriction on critical exports (for example, rare earths) - which has been raised as a possibility. Could China attempt to use the exchange rate as a means of retaliation? The Chinese authorities have denied such a possibility, but the U.S. claim of ‘currency manipulation’ by China well illustrates the issue. Recently, the possibility has been raised of restricting financial market access.

Are Trade Wars a Temporary Phenomenon?

Is the concern about trade wars soon to be replaced by other issues? Certainly, every year seems to bring a different set of forces determining exchange rates. However, the current trade conflict has the potential to be longer-lasting because of the size of the U.S. trade deficit and the unwillingness to address the U.S. budget deficit, the underlying source of the trade imbalance. There has been no indication so far that trade wars will be an “easy win.”

This precarious geopolitical situation could have a meaningful impact on the Chinese renminbi/U.S. dollar exchange rate (and on other currencies that respond to a move in the renminbi). Increased tariffs, or the threat of their imposition, on other countries as a result of separate trade or geopolitical disputes could likewise alter their exchange rate against the U.S. dollar. In the case of the U.S./China trade war, which is currently the greatest risk to international companies, if higher tariffs become more probable, the U.S. dollar could strengthen further, and potentially breach the psychologically important level of 7.00 CNY per USD. From a corporate risk management perspective, this could be a concern for exporters that earn renminbi revenues.

Achieving Cost-effective FX Risk Management

Companies facing challenges associated with volatile FX movements due to tariff increases should contact their Citi FX salesperson to evaluate cost-effective risk management responses. Various strategies are available depending on corporates’ risk profile and outlook. Citi can analyze clients’ renminbi exposures and help develop applicable solutions.

For example, if higher tariffs are threatened and the U.S. dollar strengthens further, then firms might wish to lock in FX rates to protect the value of their renminbi revenues in dollar terms. Alternatively, if the U.S. or China signals a potential resolution to trade skirmishes, the renminbi could strengthen relative to the dollar. This would increase costs for importers. Importers may wish to take advantage of current renminbi weakness and prevent their margins from being compressed. In either scenario, companies with international operations that encompass China should be vigilant about ongoing developments, and devise strategies to hedge against what may be turbulent movements in FX markets.

Stephen Leach

Stephen Leach
Managing Director & Economist Foreign Exchange Department Citigroup

Sylvia Huang

Sylvia Huang
Senior Analyst Risk Management Solutions Citigroup