So why are currencies significant for stock markets? Arguably, the main reason is that currency fluctuations have an impact on the broader economy, which affects the performance of businesses.
A fall in one nation’s currency, say the Australian dollar, will make its exports cheaper, helping businesses that sell overseas, while making imports more expensive, potentially hurting consumers and retailers.
All things being equal, a lower Australian dollar will help lift the performance of export-orientated businesses and hurt import-orientated and consumer-facing businesses, which will therefore affect stock prices.
So how does the renminbi fall fit with this dynamic? A weaker RMB makes Chinese exports cheaper and imports to China more expensive. As Australia’s largest trading partner, that’s bad news for a whole range of Aussie businesses from food producers to iron ore miners.
However, the main reason for the strong reaction on stock markets almost certainly had a lot to do with the timing of the fall, which came days after then-US President Donald Trump announced new tariffs on $US300 billion worth of Chinese goods.
Quite simply, the fall in the RMB was seen by markets as an escalation in a trade dispute that could have significant ramifications or the global economy and as a sign China, which exercises greater direct control over its currency than most western liberal democracies, may be willing to weaponise its exchange rate in the dispute.
While this is an extreme example of currency fluctuations affecting share markets, foreign exchange movements can affect stocks in other ways as well. Here are a few examples:
- Companies with overseas earnings: A weaker Australian dollar is good news for companies that earn a substantial amount of their income overseas since every US dollar they earn is now worth more back home, providing a potential boost to their bottom line and dividends, which could make its stock more attractive to investors.
- Carry trade: A lower Australian dollar can make local stocks more attractive to overseas buyers, especially if they believe the currency will rebound at some point.
Say a US investor decides to invest $US10,000 in Australian shares when the AUD is worth US70 cents and sells them a year later when the AUD has climbed to US77 cents. They would have made a 10% profit before taking into account stock price moves and dividends. This is where the so-called carry trade – in which investors borrow money in a currency where lower interest rates are available and invest it in a different currency with the goal of securing higher returns – also comes into play.
However, in the example above, if the AUD had moved in the opposite direction and fallen to US63 cents, the investor would have instead occurred a 10% loss.