How International Trade Agreements Affect Currency Exchange Rates

International trade affects the exchange rates of currencies as they create a sort of economy between countries and determine the value of their currencies. Trade is now one of the most important determinants of the modern international monetary system because with globalization being experienced at such a fast pace, trade agreements are now critical in the determination of the system. These agreements thus give rise to new trading opportunities on the international level and promote economic development. But, then again, they also cause a lot of volatility in exchange rates because of one factor or another.

The two most direct means that international trade agreements have on the exchange rates of different currencies is through trade liberalization. When two or more countries engage in a trade agreement, tariffs and other trade restrictions are usually reduced so that business people can easily transport products across borders. Therefore, there is an increase in the volume of trade, and more trade exceeds are done in foreign currency. As was earlier noted, trade activity goes hand in hand with exchange rates since the latter tends to vary due to the increased volume of trade. If forex trading becomes integral to these deals, the forex markets become much more volatile.

Image Source: Pixabay

Among all the ways that international trade agreements affect exchange rates, capital flows were found to be most directly affected. Whenever two or more countries enter into trade relations, the native companies of those countries are free to invest in each other’s economy. Outward FDI can cause an upward effect of demand in a partner country’s currency supply, and thus boost its currency value against other currencies. On the other hand, if the host country undergoes some economic problems then the FDI may be reduced or otherwise, the host country’s currency value may decline. Thus, these capital flows affect the exchange rates of currencies most directly.

International trade agreements also contain important factors such as the formation of trade areas, or currency blocks, more popularly known as the formation of, for example, EU. When countries join such unions, they undertake to follow standard economic policies and use a common currency. This tames the exchange rate risk between the member countries and can also result in reduced transaction costs. But it also brings difficulty in controlling monetary affairs and for addressing the issue of the imbalance of economic standards between members in the country.

Also, most international relations have provisions that relate to currency exchange rates. For example, some of these agreements involve setting target exchange rates or defining guidelines for exchange rate changes. Some may even go to the extent of asking countries to intervene in currency markets to ensure that they do not spiral out of control. In such circumstances, even central monetary authorities of different countries get engaged in the foreign exchanges to achieve these effects. In the context of forex markets, their actions can distort exchange rates significantly and, in the process, affect the balance of trade and, therefore, growth.

Finally, through cooperation in international trade, competition and innovation within diverse sectors of the economy can be promoted and consequently lead to the economic growth of the countries involved in trade. As trade deepens, there are realizations of economies of scale and thus there will be increased spending on research to improve productivity. However, economic development, for instance, may result in inflation and this has ramifications on the value of a specific currency. As a result, countries have to balance their economies in a bid to get the advantages out of the agreements made in the area of trade without causing harm in the aspect of currency exchange.

Hence, through trade liberalization, all forms of capital movement, creation of trade zones or currencies, setting of terms for exchange rates, and the encouragement of economic growth through more trades, international trade agreements are mostly involved in determining currency rates. Although such agreements can enhance economic activities and enhance welfare of the participating countries, it is also noted that agreements have challenges in managing exchange rates of the currency since both directional movements in exchange rates can positively or negatively impact the economic activities of the countries. Thus, the necessity of comprehension of the correlation between international trade and foreign exchange. Businesses and investors in the sphere of international trade today depend on forex trading more often, the role of which in international commerce is constantly increasing.