Central Banks Manage International Trade

You know that it is the job of the central bank to manage an economy. By setting interest rate policy, they can boost an economy, or cool it off.

Central banks also have the job of helping the market find an ideal currency price. If a currency becomes too strong, it can have short-run consequences for the economy. If a currency is too weak, then it can create short-run booms in the economy, which don’t always pan out for long-term gain.

Currencies vs. International Trade

We’re going to imagine that we’re all Americans. We use the US dollar. If the US dollar becomes more valuable, then we can buy stuff around the world at lower prices. But if the US dollar loses value, then shopping around the world isn’t such a good deal. Other countries might decide just to buy stuff from us.

Central banks can influence the supply of money, which ultimately influences the price of money. If the Federal Reserve increases the supply of money to decrease interest rates, then the Dollar will lose value. The United States will be more likely to run a trade surplus, since other countries will find it worthwhile to buy stuff domestically, whereas Americans find it less enticing to buy stuff from other countries.

A Real World Example

China is a perfect example of a country that uses its central bank to affect international trade. You might have heard before that the Chinese central bank engages in what is known as “currency manipulation” or “price fixing.” To keep its more than 1 billion people employed, the Chinese Central Bank keeps their currency values low so that they can export more than they import. This is one of the many reasons why manufacturing has become such big industry in China.

To keep a currency artificially low, China has to supply currency into the market. We demonstrate this concept with a simple diagram below:

This diagram shows the relationship between Renminbi (the Chinese currency, also referred to as “yuan”) and the US Dollar. To keep its currency cheap at a certain price, the Chinese central bank has to say, “Sure, we’ll buy any amount of dollars at this price.” By undercutting the market, the central bank makes sure that the price of Renminbi does not rise too high to hurt exports.

Because of this policy, the Chinese remain one of the biggest exporters on the planet. This correlates with a higher trade surplus, particularly with the United States. Americans buy Chinese products, and the Chinese buy…well, American Dollars with Chinese Renminbi.

In order to keep the Chinese currency cheap, the Chinese government now owns more foreign exchange reserves than any other country on the planet. That is, keeping the Renminbi inexpensive by selling it cheaply on the foreign exchange means they now own more US Dollars, Euros, Canadian Dollars, and Australian dollars than any other bank on the planet.

China has little incentive to let its currency rise in value, as it would hurt their export economy. On the other hand, the world has little incentive to stop buying Chinese goods because they are so darn cheap.

As forex traders, we have every incentive to watch central banks to see how their plans to affect currency values might create ripples in the market.

Getting Rich on Central Banks

Slowly, China has allowed their currency to appreciate, starting in 2005, which has made many forex traders quite wealthy. If you had paid attention to the People’s Bank of China (their central bank) you could have made mega-pips in the years that followed their decision to allow slow appreciation! Check out this chart, which shows the Renminbi’s five-year surge against the US Dollar:

That chart looks like it has some serious money making potential. And it does! Traders who were keeping a watchful eye on the People’s Bank of China made many millions of dollars on this trade.

We still have two more concepts to cover in fundamental analysis—capital flows, and political stability. You’re deep in the mix, now, so stay in tune so that we can bring it all together.