[The Editors' Verdict]A Breeze from the Trade Truce, but Uncertainties Remain

Kim Kyung-soo, Professor Emeritus, Department of Economics, Sungkyunkwan University

The Phase 1 US-China trade agreement has brought a breath of fresh air to the previously subdued international foreign exchange and financial markets. With China removed from the currency manipulator list, the yuan exchange rate has declined, and emerging market currencies have strengthened due to increased risk asset preference. Global stock prices, centered on emerging markets, are also on the rise. The weakening of the US dollar has acted as a positive factor in this trend.

Over the past 20 years, as the global economy has integrated, the US dollar has dominated the global economy. As shown in statistics from the Bank for International Settlements (BIS), the dollar accounts for over 88% of foreign exchange transactions on one side of the currency pair, demonstrating its overwhelming share in forex trading. Moreover, the monetary policy of the US Federal Reserve (Fed) acts as the driving force behind the global credit cycle. Global banks take advantage of the weak dollar environment under low interest rates to distribute dollar liquidity worldwide, and when a strong dollar emerges under high interest rates, they initiate a cycle of withdrawing the previously supplied dollar liquidity.

Meanwhile, emerging market central banks have no choice but to follow the Fed's monetary policy direction regardless of their exchange rate regimes. Otherwise, these countries could face massive capital inflows and outflows that are difficult to manage.

This phenomenon stems from the US dollar's status as the key currency. Although the United States accounts for only about 15% of global GDP based on purchasing power parity, there is no alternative market that can replace the dollar funding market's high liquidity and sophisticated maturity structure.

The problem lies in the fact that the dollar is also used as a settlement currency, causing exchange rate adjustments to distort the real economy. For example, if the won-yuan exchange rate rises, South Korean products become more price competitive, leading to increased exports to China and decreased imports. This is because the deterioration in trade terms due to the exchange rate rise causes expenditure demand to shift from Chinese products to South Korean products. However, for the expenditure switching effect to work as economic textbooks suggest, South Korean exports must be settled in won and Chinese exports in yuan.

However, over 90% of trade between the two countries is settled in US dollars. Therefore, unless there is a corresponding change in the dollar price of traded goods, the adjustment of the won-yuan exchange rate has less than a 10% chance of triggering the expenditure switching effect. This is easily understood by considering trade with the US, assuming all traded goods are priced in dollars, meaning that even if exchange rates change, trade terms remain unchanged. When the won-dollar exchange rate rises, US imports, i.e., South Korean exports, are not affected at all. Meanwhile, US exports, i.e., South Korean imports, inevitably decrease because the price of US imports priced in won rises.

Thus, when the value of the dollar rises against all world currencies, not only do US exports decrease, but exports among other countries also decline. Ultimately, global trade excluding exports to the US contracts. Conversely, when the dollar exchange rate falls, global trade expands. Research shows that a 1% appreciation (depreciation) of the dollar against global currencies results in a 0.6% decrease (increase) in global trade volume.

The US-China trade agreement has clearly brought positive effects. The US dollar index, composed of a basket of major trading partner currencies, has been declining since October last year, marking a shift to a weaker dollar. This is fortunate for South Korea’s economy, which is highly dependent on exports.

How long this rally will last remains to be seen, but experts generally do not expect it to continue for long. The term "ceasefire" rather than "trade agreement" is more appropriate, as it is uncertain how future trade disputes will unfold and what geopolitical risks lie ahead. Last week, the International Monetary Fund (IMF) revised its forecast for this year’s global trade growth rate down to 2.9% from 3.2% in October last year.

Kyungsoo Kim, Professor Emeritus, Sungkyunkwan University