How Can Tariffs Affect Exchange Rates and Currencies?

Tariffs can be used by government policymakers to protect domestic industries from competition and correct trade imbalances, but they also influence exchange rates and currencies in ways that affect business profits and investment decisions. For example, if adding or raising tariffs  reduces imports from a particular country, it can cause that country’s currency to be devalued as demand for its currency declines. However, the relationship between currencies and exchange rates is complex and outcomes of changes to tariffs may vary depending on a variety of factors, including trade balances, foreign exchange markets and investor sentiment. 

A financial advisor can also help you understand what tariffs, exchange rates and currencies could mean for your investment portfolio. 

What Are Tariffs, and How Do They Work?

Tariffs are taxes imposed by governments on imported goods to protect domestic industries and generate revenue. When a tariff is applied, the cost of importing goods increases. This often makes foreign products less competitive in the domestic market.

For example, if the U.S. imposes a 20% tariff on steel imports, any company bringing steel into the U.S. must pay an additional 20% of the steel’s value to the government. As a result, domestic steel producers may gain a competitive edge, as their products become relatively cheaper when compared with imported steel.

Tariffs can take various forms, including:

• Ad valorem tariffs: A percentage of the value of the goods
• Specific tariffs: A fixed fee per unit of goods
• Compound tariffs: A combination of both

Governments use tariffs to influence trade policies, address trade imbalances or retaliate against other nations’ trade practices. While they aim to support domestic industries, tariffs can also lead to higher prices for consumers, as well as trade wars that can have a wide range of both positive and negative economic effects. 

How Tariffs Affect Exchange Rates Between Countries and Currencies 

Tariffs influence exchange rates by altering trade flows and affecting the demand for currencies.

Tariffs can favor a stronger domestic currency by reducing imports and improving the trade balance. A positive trade balance increases the demand for the domestic currency in international markets.

Here’s how it works: When a country imposes tariffs on imports, it often reduces the volume of goods coming into the country. This can decrease the demand for foreign currency. This is because fewer imports mean fewer payments to foreign suppliers. In turn, this reduced demand can lead to a stronger domestic currency relative to the foreign currency.

For example, if the United States imposes high tariffs on goods from China, U.S. businesses may purchase fewer goods from China. Consequently, there will be less demand for China’s currency, potentially weakening it when compared with the U.S. dollar. However, retaliation by China, such as imposing tariffs on U.S. exports, could create counterbalancing effects.

Tariffs can carry risks, including economic slowdowns, higher inflation and reduced foreign investment. These may weaken the domestic currency. So, if tariffs disrupt global supply chains, businesses may face higher costs, leading to reduced economic output and less investor confidence in the domestic currency.

Consider a real-world example: During the U.S.-China trade war, the imposition of tariffs led to fluctuations in both the U.S. dollar and the Chinese yuan. While the tariffs aimed to protect domestic industries, they also created uncertainty in global markets, leading to currency volatility.

Other factors, such as central bank policies and market sentiment, also play a role in determining exchange rates. All things considered, the relationship between tariffs and exchange rates is complex and multifaceted.

Should Investors Be Concerned About Tariffs?

Yes, investors should monitor tariffs. Tariffs can impact currency values, trade flows and the overall economic environment. Changes in tariffs may create opportunities or risks depending on the industries and markets affected. 

For example companies heavily reliant on imported raw materials may face higher costs, which could affect their profitability and stock performance. On the other hand, domestic industries protected by tariffs might experience a temporary boost in competitiveness. These may be factors to consider when balancing your portfolio. 

Tariffs can also lead to broader economic repercussions, such as inflation or reduced consumer spending, which could influence market trends. By staying informed about tariff policies, you can anticipate shifts in the market, and adjust your portfolio to mitigate risks or capitalize on emerging opportunities. 

How Can Investors Prepare for Tariffs?

Tariffs can influence exchange rates and currency values, creating both risks and opportunities for investors. Higher tariffs may lead to reduced imports and exports, affecting global trade balances and causing currency fluctuations. Here are five common things to consider:

• Monitor currency movements: Tariffs often lead to shifts in exchange rates as countries adjust their trade policies. A weakening domestic currency can make exports more competitive but increase costs for imported goods. Investors should keep an eye on currency trends and assess how fluctuations may impact multinational companies or foreign investments.
• Invest in currency-hedged funds: Currency-hedged funds help protect against exchange rate volatility by minimizing the impact of currency fluctuations on returns. These funds can provide more stability for investors with international holdings during periods of trade uncertainty.
• Diversify across markets: Investing in a mix of domestic and international markets can help offset risks tied to tariffs and exchange rates. Diversification reduces reliance on any single economy and provides exposure to regions that may benefit from shifting trade patterns.
• Focus on export-driven companies: Companies that benefit from a weaker domestic currency due to increased export competitiveness may present growth opportunities. Investors can look for businesses in industries such as agriculture, manufacturing and energy that are positioned to capitalize on changing trade dynamics.
• Consult a financial advisor: A financial advisor can help investors develop strategies to manage currency exposure, assess risks tied to tariffs and rebalance portfolios as market conditions evolve.

Bottom Line

Tariffs can have far-reaching effects on exchange rates and currencies and these impacts can influence trade dynamics and economic stability. For investors, understanding whether tariffs favor stronger or weaker currencies is essential for navigating the complexities of global markets. While tariffs may strengthen a currency by improving trade balances, they can also introduce risks such as inflation and economic slowdowns. Staying informed about tariff policies and their implications can help you make informed investment decisions and adapt to changing market conditions.

Tips for Investment Planning

• A financial advisor can recommend inflation-resistant assets to help preserve your purchasing power. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• SmartAsset’s inflation calculator can help you estimate how rising prices could affect your purchasing power over time.

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