Understanding the Impact of Tariffs on Exchange Rates and Production Costs

Tariffs are commonly used by governments to protect local industries from foreign competition or to address trade imbalances. While their primary intent may seem straightforward, tariffs often set off complex economic reactions that extend beyond the targeted goods. One of the most significant and often overlooked consequences of tariffs is their effect on exchange rates, which can lead to unexpected shifts in the costs of production and imports.

When a new tariff is introduced, it can reduce demand for the currency of the exporting country, resulting in fluctuations that affect both sides of the trade relationship. For companies that rely on international suppliers, these shifts can translate into higher import costs and have an impact on their bottom line. A tariff doesn’t just add a direct cost, it also indirectly fluctuates exchange rates, which can further complicate pricing, profitability, and production planning.

This blog will explore how tariffs influence exchange rates and how these fluctuations affect both importers and suppliers. By examining the tariffs back in 2018, when the U.S. imposed tariffs on hundreds of billions of dollars worth of Chinese goods, we’ll reveal how these tariffs contributed to changes in the U.S. dollar (USD) and Chinese renminbi (RMB).

Understanding tariffs and exchange rates

Understanding tariffs and exchange rates reveals how tariffs on imported goods affect not only the price of those goods but also the demand for the currencies involved in trade. At a fundamental level, tariffs can influence exchange rates by altering the flow of imports and exports between countries. When tariffs reduce imports from a particular country, it also decreases demand for that country’s currency, as fewer businesses and consumers are purchasing goods priced in that currency. This shift can lead to a depreciation of the exporting country’s currency relative to the currency of the importing country.

The U.S.-China Tariff Example: How the RMB Depreciated

A notable example was seen during the 2018 U.S.-China trade war. As the U.S. imposed tariffs on Chinese products, demand for Chinese goods decreased. This decline, combined with other economic factors, led to a depreciation of the RMB relative to the U.S. dollar. 

From the chart below, you can see that the USD started to appreciate against the Chinese RMB in March 2018. This was also when President Trump announced the administration would impose a 25% tariff on imported steel and a 10% tariff on imported aluminum according to Tax Foundation. Shortly after this announcement, the USD appreciated vs the RMB.

For U.S. importers who were buying from China, this depreciation meant that they paid slightly less in dollar terms for Chinese goods, partially offsetting the increased cost imposed by the tariffs. 

This devaluation of the RMB was partially driven by market reactions, as investors anticipated lower demand for Chinese exports. In addition, there was no urgency to stop the RMB from weakening. By allowing its currency to weaken, China effectively made its goods more affordable in global markets, helping its exporters maintain competitiveness despite the added tariff costs.

The fluctuating exchange rate created mixed outcomes for businesses on both sides:

For U.S. Importers: The devaluation of the RMB helped soften the impact of tariffs, as American companies paid less in USD terms for the same goods from China. This currency shift provided some relief to U.S. importers, helping to balance out the increased costs imposed by tariffs. However, this advantage came with volatility, as exchange rates continued to fluctuate in response to ongoing trade negotiations and uncertainty.

For Chinese Exporters: The weaker RMB helped Chinese businesses remain competitive despite higher tariffs on their goods. Since their products became cheaper in foreign markets, they could partially offset the tariff costs by maintaining or even expanding their market share. This currency effect also helped to minimize the revenue impact of the tariffs for many Chinese manufacturers, even as they faced increased costs in some cases due to tariffs on raw materials or intermediate goods imported from the U.S.

Effects on Production Prices from Suppliers

When tariffs alter exchange rates, the impacts extend beyond import prices, often affecting the cost structure for suppliers in the exporting country. For suppliers, currency devaluation might appear beneficial on the surface, as it can make their goods more competitive in foreign markets. However, exchange rate fluctuations triggered by tariffs can also increase production costs. 

Rising Input Costs Due to Currency Depreciation

A weaker currency, such as a depreciated RMB means that suppliers face higher costs for any imported materials priced in foreign currencies. For instance, a Chinese manufacturer sourcing components or raw materials from countries outside China would find their costs rising as the RMB loses value against other currencies. As these input costs climb, suppliers may have to either absorb the added expenses or pass them on to their customers. 

Looking Forward: Strategies for Importers During Currency Fluctuations

As tariffs continue to shape global trade, companies on both sides of the supply chain face the challenge of navigating the unpredictable impacts of tariffs and exchange rate volatility. To remain resilient, importers must adopt strategies that allow them to mitigate financial risks, adapt to sudden market shifts, and manage costs in an environment where trade policies can change rapidly.

Flexibility and Diversification in the Supply Chain

One of the most effective ways to manage the impact of tariffs and currency fluctuations is to diversify your supply chain. As an importer, if you rely on a single supplier then you are vulnerable to tariffs or exchange rate shifts affecting that particular region. By sourcing from multiple suppliers across different countries, importers can spread risk and reduce the likelihood that tariffs or currency volatility will disrupt their operations.

Establishing Flexible Pricing Models

To manage the challenges posed by tariffs and exchange rate volatility, businesses can also implement flexible pricing models that account for changes in economic conditions. For example, including price adjustment clauses in contracts can enable you to renegotiate prices with suppliers if the exchange rate shifts beyond a certain threshold. This approach allows companies to share the financial burden and reduces the risk of one party bearing the full impact of a sudden economic change.

Monitoring Trade Policies and Economic Indicators

When trade policies are shifting it’s best to stay informed on what is going on. By closely monitoring new trade agreements, tariff announcements, and economic indicators such as inflation rates and central bank policies, companies can proactively anticipate changes that could affect their supply chains or production costs. Importers and suppliers alike should establish processes to regularly evaluate how trade policies and currency trends could impact their operations, allowing them to act swiftly if conditions change.

Building Strong, Transparent Partnerships

The uncertainty surrounding tariffs and exchange rate volatility underscores the importance of strong, transparent relationships between importers and suppliers. Open communication can help both parties work together to find mutually beneficial solutions to challenges such as increased costs or currency fluctuations. By collaborating on cost-sharing strategies or jointly exploring alternative sourcing options, importers and suppliers can create a more stable business relationship and enhance their ability to navigate economic uncertainty together.

Conclusion 

The relationship between tariffs and exchange rates presents a unique set of challenges and opportunities for businesses engaged in global trade. When tariffs are imposed, they often lead to shifts in currency values, which can significantly affect the cost of imports, production prices, and profit margins for both importers and suppliers.

To successfully manage these challenges, companies must adopt flexible strategies, including diversifying suppliers, implementing dynamic pricing models, and utilizing currency hedging tools. By staying agile and informed about trade policies and economic shifts, businesses can minimize risks and protect their bottom lines in the face of tariff-driven exchange rate fluctuations.

Ultimately, by proactively planning for these uncertainties and strengthening partnerships, importers and suppliers can turn potential risks into opportunities, ensuring long-term stability and success in a constantly evolving global market.

By: Jared Haw