FX International Payments
By Frances Coppola
A study by the National Bureau of Economic Research (NBER) and Harvard University professor Gita Gopinath found that the proportion of global imports invoiced in USD was 4.7 times total U.S. imports, and the proportion of global exports invoiced in USD was 3.1 times total U.S. exports. This was a far higher proportion than the second-most-frequently used currency, the euro, for which total global imports and exports were only 1.2 times the Eurozone's international trade. The study said that "the overwhelming share of world trade is invoiced in very few currencies, with the dollar the dominant currency."1
The difference between the U.S. and the rest of the world is striking, according to the report. Only 7 percent of the U.S.'s imports are invoiced in a currency other than USD. In contrast, over 60 percent of Australia's imports are invoiced in a foreign currency: the figure is similar for the U.K. For some other countries the proportion is even higher: over 90 percent for Indonesia, South Korea and Turkey. Even in Japan, whose currency is a global "safe haven," 71 percent of imports are invoiced in USD, though only about 13 percent come from the U.S.2 Some of these imports are oil and commodities, which are priced in USD because they are sold on global markets. But it seems that non-commodities are also often traded in USD, including between countries such as Japan and Indonesia.3
Since U.S. imports are almost entirely in USD, changes in USD exchange rates don't significantly affect import prices, and therefore have little effect on domestic inflation. This helps the Federal Reserve to maintain full control over monetary policy. Gopinath's report calls the U.S.'s insensitivity to externally generated inflation "privileged insularity."4 It corresponds to USD's "exorbitant privilege" in asset markets arising from its premier reserve currency status.5
In contrast, the dominance of USD in international trade means that the Fed's monetary policy decisions affect inflation in other countries, whether or not they trade significantly with the U.S. When the Fed increases interest rates, the U.S. dollar tends to appreciate, depressing the exchange rates of all other currencies in relation to USD. Because a large part of the world's trade is invoiced in USD, import prices in local currency rise in other countries, increasing domestic inflation.
Economic theory's "trilemma" says that it is not possible to have a fixed or managed exchange rate, free movement of capital and independent monetary policy. Countries that have a fixed or managed exchange rate in relation to USD may be forced to follow Fed monetary policy changes to maintain their currency peg.
However, economist Hélène Rey of the London Business School, in another paper with NBER, warns that even countries with floating rate regimes can face a "dilemma." Because of the dominance of the U.S. dollar in global asset markets, countries with floating rates may be forced to follow Fed monetary policy decisions, regardless of local conditions, to prevent destabilizing movements of capital.6 The dominance of USD in international trade could be said to create a similar dilemma for countries with floating exchange rates. If a large part of their import-export trade is in USD, they may be forced to follow Fed monetary policy changes to keep inflation under control.7 The greater the proportion of the country's imports invoiced in USD, the more important the USD exchange rate becomes for domestic inflation and hence for monetary policy decisions.
When a high proportion of a country's trade is invoiced in USD, movements in its currency exchange rate against other countries become much less significant, even if they are important trade partners. The USD exchange rate replaces the trade-weighted exchange rate as the principal indicator of the country's competitiveness, and the terms of trade between the country and its trade partners (except the U.S.) become insensitive to other exchange rate movements. A strong USD will automatically raise import prices and reduce export prices in local currency, even if other exchange rate relationships are moving in the opposite direction. At an individual country level, a rising USD should therefore depress imports and increase exports.
However, when a high proportion of global trade is invoiced in USD, the terms-of-trade effect of a rising USD exchange rate can be less beneficial. New research shows that since a high proportion of global trade is invoiced in dollars, the USD exchange rate is now the principal driver of global trade volumes and prices.8 When global prices rise because of a strengthening USD exchange rate, international businesses may cut export prices to offset the USD appreciation for their customers. However, they may be unwilling to cut export prices if their input costs are rising. Customers may therefore reduce their orders, or substitute cheaper goods. But one country's export is another country's import. When everyone is reducing orders in response to a strengthening USD, therefore, trade volumes fall for all countries, including the U.S.
Research shows that if the USD exchange rate appreciates by an average of 1 percent against all other currencies in the world, within a year there will be a 0.6-0.8 percent decline in the volume of total trade between countries in the rest of the world. This applies regardless of other economic influences such as the global business cycle.9
As USD becomes ever more important in global trade, international businesses may find working entirely in USD increasingly attractive. However, for businesses with a continuing need to handle multiple currencies, paying close attention to Fed monetary policy signals and to the behavior of the USD exchange rate may help them to devise more effective FX risk management strategies.
With 17 years' experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. The International Price System, Gopinath, Harvard University, and the National Bureau of Economic Research; https://scholar.harvard.edu/files/gopinath/files/paper_083115_01.pdf
5. “Exorbitant Privilege and Exorbitant Duty,” Rey http://www.helenerey.eu/RP.aspx?pid=Working-Papers_en-GB&aid=71510901685_67186463733
6. “Dilemma not Trilemma: the Global Financial Cycle and Monetary Policy Independence,” Rey, London Business School, and the National Bureau of Economic Research; http://www.helenerey.eu/AjaxRequestHandler.ashx?Function=GetSecuredDOC&DOCUrl=App_Data/helenerey_eu/Published-Papers_en-GB/_Documents_2015-16/147802013_67186463733_jacksonholedraftweb.pdf
7. The International Price System, Gopinath, Harvard University, and the National Bureau of Economic Statistics; https://scholar.harvard.edu/files/gopinath/files/paper_083115_01.pdf
8. “Global Trade and the Dollar,” National Bureau of Economic Research; http://www.nber.org/papers/w23988