COVID-19’s Influence on Exchange Rates

The interplay of the evolution of the COVID-19 virus as it spread across the world with the dynamics of exchange rates has been fascinating to observe. With exchange rates, there are no absolutes and everything is relative, and that is exactly how it worked with the virus. Countries seeing sharp daily rises in new COVID-19 cases typically saw their currencies weaken. When countries made progress containing the spread of the virus, that often set the stage for currency strength.

From the perspective of fundamentals, the influence of the virus on currency markets worked its way through the channel of changing relative expectations of future economic growth. Countries with healthy economies have the ability to attract global capital flows, and capital flows are an important driver of exchange rates. When the virus first hit a country or region hard, economic growth expectations would be downgraded in fear that parts of the economy might need to be shut down. By contrast, as a country gained better control of the virus and daily new cases declined, optimism about the re-opening the economy took control of the market narrative. To illustrate our analysis, let’s take two exchange rate cases relative to the US dollar – Chinese yuan and the euro – from the pandemic of 2020 to see how this analytical framework helps to explain some of the currency moves that were observed.

We will start with the Chinese yuan. The virus started in China early in 2020. The city of Wuhan and the province of Hubei were almost entirely shut down for a month and both domestic and international air travel were highly restricted. Not surprisingly, expectations about Chinese economic growth tumbled while US was still not impacted by the virus. The Chinese yuan initially weakened during the early stages of the pandemic through the end of May. From June onward, though, it became apparent that China had made progress in controlling the spread of the virus. The economy came back strong, which can be observed in the comeback pattern of domestic air travel. Simultaneously, in the summer of 2020, as China was experiencing its economic rebound, the US economic expectations were hit by a second wave of the virus as it spread through Sun Belt of the country. The relative juxtaposition of the virus being contained in China and still spreading in the US was part of the reason why the Chinese yuan rallied strongly in the July-September period. The Chinese currency rallied from 7.16 yuan to the US dollar in late May to 6.75 yuan/US dollar at the end of September 2020, about a 6% gain.