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How Tariffs Affect Foreign Currency Exchange Rates, Importers, and Exporters

By Frances Coppola

For many U.S. businesses, trade tariffs present challenges. Businesses potentially face higher costs due to more expensive imported inputs, while revenues may fall if they have to raise prices in response to the higher costs. But the U.S. dollar’s exchange rate also responds to trade tariffs. Economic theory shows how foreign currency exchange rate movements can help negate the direct cost impact of tariffs on a country’s businesses – but potentially create different problems for that country’s exporters.

The Relationship Between Trade Tariffs and Foreign Currency Exchange Rates

 

The “symmetry theorem” proposed by economist Abba Lerner in 1936, and since confirmed by many empirical studies, shows that import tariffs tend to be negated by foreign currency exchange rate rises.1

 

Lerner’s “symmetry theorem” is most often applied to border adjustment taxes, which combine an import tax (or tariff) with an export subsidy. Lerner said that the foreign currency exchange rate would rise enough to effectively eliminate both the import tariff and the export subsidy, leaving importers no worse off and exporters no better off. However, Lerner’s theorem also applies when there is no export subsidy. Importers would be unaffected by the tariff, but exporters would be worse off by the amount of the tariff.

 

Perhaps surprisingly, then, import tariffs are thus effectively a tax on exports.

 

In an April 2017 working paper, economists at the Peterson Institute for International Economics showed that imposing border adjustment taxes does indeed cause the real effective exchange rate (REER) to rise, fully negating the domestic price increase caused by the tax.2 The REER is the average foreign currency exchange rate versus all a country’s trade partners, weighted by trade volume and adjusted for inflation. It is widely regarded as a measure of a country’s competitiveness. A rising REER indicates that the country’s exports are becoming less competitive.

 

The economist Robert Mundell showed that when exchange rates are floating, new import tariffs tend to reduce the U.S. trade deficit, which would increase the dollar’s REER. He explained that even though the tariff would encourage U.S. businesses and households to “buy American,” the decline in export competitiveness due to the rising REER could cause U.S. output and employment to decline.3 Maurice Obstfeld, chief economist of the International Monetary Fund, estimated that a 20 percent tariff on imports from East Asia could cause the U.S. dollar’s REER to rise by 5 percent and U.S. economic output to fall by 0.6 percent over five years.4

 

How Import Tariffs Raise Foreign Currency Exchange Rates

 

Imagine that the U.S. applies a tariff of 10 percent on the value of all imports from the mythical Duchy of Grand Fenwick (this is called an “ad valorem” tax5). In the U.S., prices of the imported goods would rise by 10 percent. Faced with higher prices, U.S. businesses and households would be likely to cut back spending on goods imported from Grand Fenwick, perhaps substituting goods manufactured in other countries or in the U.S. itself.

 

As a result, U.S. import businesses would order fewer goods from their Grand Fenwick suppliers. Since the higher dollar price of imports would be entirely due to the tariff, and the tariff would go to the U.S. government, those Grand Fenwick suppliers would receive fewer dollars even though the price of their exports was higher. Grand Fenwick companies typically exchange dollars for their Fenwickian Pound (FP): their demand for FP on forex markets would decline as their dollar revenues dropped. Thus, provided the supply of FP on the forex market remained constant (i.e. the Grand Fenwick authorities didn’t intervene to reduce it, for example by selling dollar reserves), the dollar exchange rate of the FP would naturally tend to fall in response to U.S. import tariffs on Grand Fenwick goods.

 

U.S. import businesses would end up nominally worse off because their dollar revenue would decrease, but since the value of their dollars would have risen, they would be no worse off in real terms. Similarly, Grand Fenwick exporters would receive fewer dollars, but their dollars would buy more FP. Thus for U.S. importers and Grand Fenwick exporters, U.S. import tariffs would have no real financial impact. This would still apply even if U.S. businesses paid for their Grand Fenwick imports in FP, since they would have to exchange dollars for FP in order to make the payments.

 

For U.S. export businesses, however, a rising U.S. dollar exchange rate due to new import tariffs could mean lower revenues and higher risks.

 

How Import Tariffs Affect Export Businesses

 

Today, up to 80 percent of world trade is conducted in dollars. Invoicing entirely in U.S. dollars protects businesses from the FX risk of a rising dollar exchange rate. Of course, many export businesses are also importers; these businesses would find their input costs rise due to tariffs, but the rising foreign currency exchange rate would tend to negate the effect, as described above.

 

However, invoicing foreign customers in dollars when the U.S. dollar exchange rate is rising increases revenue, cash flow, and credit risk for U.S. businesses. When foreign customers’ cost of imports from the U.S. increases in terms of their local currency, they tend to cut back purchases. They may also delay payment in the hope that the exchange rate falls. Some may even default on payments if they experience difficulties obtaining dollar finance. For exporters, therefore, import tariffs may cause a significant fall in revenue. This applies whether or not U.S. exporters actually use foreign currencies themselves.

 

The

Takeaway:

Import tariffs effectively divert dollars from forex markets to the U.S. government and domestic economy. As a result, the international supply of dollars shrinks, causing the U.S. dollar’s foreign currency exchange rate to rise. This may help to protect U.S. import businesses from the effects of tariffs, while domestic businesses may benefit from tariffs if customers buy more locally produced goods. However, exporters may find the rising dollar exchange rate makes trading conditions more difficult.

Frances Coppola - The Author

The Author

Frances Coppola

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.

Sources

1. “The Macroeconomic Effects of Trade Tariffs: Revisiting the Lerner Symmetry Result,” International Monetary Fund working paper; https://www.imf.org/~/media/Files/Publications/WP/2017/wp17151.ashx
2. “Effects of Consumption Taxes on Real Exchange Rates and Trade Balances,” Peterson Institute for International Economics working paper; https://piie.com/system/files/documents/wp17-5.pdf
3. “Flexible Exchange Rates And Employment Policy,” The Canadian Journal of Economics and Political Science; https://www.jstor.org/stable/pdf/139437.pdf?seq=1#page_scan_tab_contents
4. “Tariffs Do More Harm Than Good At Home,” IMFBlog; https://blogs.imf.org/2016/09/08/tariffs-do-more-harm-than-good-at-home/
5. “Ad Valorem tax,” Economics Help; https://www.economicshelp.org/concepts/ad-valorem-tax/

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