International Trade Agreements Result in More Stable Currencies

When countries sign a trade agreement, they anticipate boosts to their economies from a more vigorous exchange of goods. Such pacts produce additional positive outcomes, including more stable exchange rates for both partners according to new research from the University of Minnesota. 

Currency volatility falls after a trade deal, making forging such deals less risky for both countries. Carlson School of Management Assistant Professors Erik Loualiche and Colin Ward, and graduate students Ramin Hassan, ‘22 PhD, and Alexandre Reggi Pecora, ‘23 PhD, published their findings in the Journal of Financial Economics.

The relationship between international trade and exchange rates has been notoriously difficult to establish and quantify. The researchers evaluated import surges after trade deals to reveal the effect of trade on currency risk. Their modeling and analysis proved their hypothesis: increasing trade lowers the risk of exchange rate volatility.

“When countries trade more with each other, their economies become more aligned, making their exchange rate more stable and less risky,” Loualiche says. “It’s hard to find a relation between the exchange rates of two countries and how much they trade. We found that trade deals grow trade between countries and normalize their exchange rates, leading to less risk in their currencies.”

In addition, the research team determined: 

• The typical trade deal raises bilateral imports across both countries by 50 percent over five years, while leading to a drop in all measures of systemic exchange rate risk.
• The share of systematic risk, along with other measures of general risk, fall by one-third compared to the standard deviation across countries.
• Countries with emerging economies disproportionately benefit from trade deals as their currencies experience more reductions in volatility compared to those with developed economies. 

This last finding was unexpected, Ward says. The researchers compared deals between two major economies and deals between developed and emerging economies. While developed economies’ currency stays relatively stable regardless of the new trade pact, the developing countries’ currency becomes much less volatile post-deal.

“Currencies of emerging markets have a lot of risk prior to signing deals with larger countries,” Ward says. “Trade deals matter much more for emerging markets than they do for large economies.”

This research demonstrates that the gains from trade are far-reaching and mutually beneficial, including lowering risk for both sides. “As countries trade between each other, they have more stable relationships,” Loualiche says. “One of the manifestations of that is through the exchange rate. When there is more trade between countries, we have less risk, and more normalization of the exchange rate.”

Ultimately, this new knowledge about reduced exchange rate risk could boost trade between established and emerging economies, Ward says. It also may pave the way for more foreign direct investment and capital flow across countries, as this lower risk increases developed countries’ willingness to trade and invest in developing nations.