Trade deals, tariffs, and trade wars: Research sheds light on currency risks and vulnerable economies

Like nearly all Canadians, finance expert Colin Ward is keeping a keen eye on the news, watching the ongoing tariff trade war initiated by U.S. President Trump. Given his position as associate professor at the Alberta School of Business, Ward is used to thinking about trade. Recently, he has been considering the economic consequences of superpower trade wars. 

In an article entitled International Trade and the Risk in Bilateral Exchange Rates, he explored what happens when countries sign trade deals and how a hypothetical trade war could impact international economies. 

“There was this idea in economics that if you trade more through countries, their exchange rates should become more stable; however, that was just a theoretical prediction. I was not sure if it was true, so my colleagues and I decided to test it out,” says Ward. 

It took years to conduct the research needed for this article, Ward says, but the team looked at about 40 countries and mapped out their trade import shares on a big scatter plot. They found that on average, a typical trade agreement increases bilateral trade by 50 per cent over a five-year period. This boost in trade activity corresponds to a reduction in systematic currency risk by about one-third of a standard deviation across countries — in other words, after countries sign a trade deal, their currency exchange rates become more stable.

“Trade deals aim to connect economies, making them more reliant on each other. This interconnectedness means that when unexpected events like pandemics or wars happen, both countries’ economies tend to react similarly. This shared experience helps stabilize the value of their currencies relative to each other, reducing the risks associated with fluctuating exchange rates,” says Ward. 

While Ward expected that bilateral trade would affect the involved countries, he did not anticipate how peripheral countries — those that are farther away geographically and experience less trade volume — would be affected. Part of this research looked at how such countries would be affected by a hypothetical trade war between the U.S. and China (a circumstance that is no longer hypothetical: the U.S. recently imposed tariffs on China, and China responded with retaliatory tariffs of their own).

Under these “superpower trade war” conditions, Ward’s team looked at how global currency risks would rise and which countries would be most negatively affected. They found that the negative effects on exchange rates would be strongest for smaller, less-connected economies.

“Picture a hub and a spoke on a bicycle wheel. In the middle is the U.S., and then there’s China, and the EU. Those are the three hubs of this currency trade network, which is what we have,” says Ward. 

In other words, those countries that are not even directly involved are the ones who bear the brunt of the trade war, says Ward. He says this unexpected finding is best explained through the trade model they used, called a gravity model. It’s an analogy that compares trade to our solar system, with the planets representing countries. 

“GDP in the model is like a planet’s mass. More mass means more inertia and therefore big planets (countries with big economies) are harder to move — they’re relatively unaffected by things like trade wars as their large size insulates them,” he says.

“Smaller planets (countries), on the other hand, are more likely to have their trajectory/trade flows altered. In some sense, a US-China trade war would distort the current hub-spoke system. As the system adjusts to a new equilibrium, the smaller countries find themselves being moved around a lot more while the U.S. and China basically stay as hubs.” 

So, how will Canada fare as a result of U.S. tariffs on it and on other countries?

“Canada’s strong trade ties and agreements may provide some protection, but its relatively smaller size compared to major powers could leave it exposed to increased currency risk in certain trade war scenarios,” says Ward.

While Canada may be somewhat buffered, as the global tariff war goes on, we will experience inflation — as will the U.S. — says Ward. This is unfortunate because both countries are already experiencing a cost-of-living crisis. 

As global trade tensions continue to make headlines, Ward’s research offers valuable insights into the far-reaching effects of trade policies beyond just import and export figures. It underscores the interconnectedness of the global economy and highlights how changes in trade relationships can have ripple effects throughout the financial system.  It’s abundantly clear why Ward finds the topic interesting — trade affects everybody.

Read this paper’s abstract at doi:10.1016/j.jfineco.2023.103711

Colin Ward's research interests include currencies, trade, intangible capital, bonds