Not Just Deficits: How Trade Networks, Not Balances, Drive Currency Markets

maj. 06, 2025

As governments contend with rising tariffs, economic nationalism, and geopolitical tensions—from the U.S.-China trade war to sanctions and supply chain shocks driven by war and climate change—understanding how trade influences currency markets has become a pressing concern.

A new study provides a fresh perspective. In The Trade Imbalance Network and Currency Returns, Ai Jun Hou (Stockholm University), Lucio Sarno of (Cambridge University), and Xiaoxia Ye (University of Nottingham) argue that the structure of global trade relationships —not just the size of a country’s trade balance—can help explain and predict movements in exchange rates.

Rather than treating trade as a collection of isolated deficits and surpluses, the authors view it as a network of imbalances, with each country connected to others through chains of exports and imports. Their central insight: a country’s position in this network matters as much as, if not more than, the size of its trade deficit or surplus.

A country that is deeply embedded in global trade flows—interacting with many others directly and indirectly—carries more systemic importance. If such a country runs a persistent imbalance, it creates more complex risks for investors and financial intermediaries who buy and sell its currency, the study shows. As a result, its currency must offer higher returns to compensate for that risk.

Beyond Simple Deficits

Economists have long used a country’s net trade position as a shorthand for currency pressure: more imports than exports, and the currency may weaken. But this ignores the tangled reality of global commerce. Changes in one trade relationship often affect others—and those effects ripple across borders.

To capture that complexity, the researchers construct what they call the trade imbalance network. Each link represents not just the volume of trade between two countries, but the direction of imbalance—who owes whom. They then calculate how central each country is within this network and combine that with a measure of how volatile its currency tends to be. The result is a score called the Centrality-Based Characteristic, or CBC.

What the CBC Reveals

Countries with high CBC scores, such as Mexico or New Zealand, are more central in the network and have more volatile currencies. Their currencies tend to offer higher expected returns, reflecting greater compensation for risk. Countries with low CBC scores, such as Japan or Thailand, are more peripheral and more stable; their currencies offer lower returns.

Using data from 41 currencies between 1995 and 2021, the authors find that the CBC is a strong predictor of exchange rate movements. Currencies ranked by CBC delivered consistently high returns relative to their risk—outperforming well-known strategies like the carry trade, which profits from differences in interest rates between countries.

“Sorting currencies on CBC generates strong predictability of currency excess returns,” the authors write. “The CBC factor captures different information” than other well-known indicators, such as interest rate spreads or market volatility.

The Domino Effect of Trade Shocks

The framework also helps explain why trade conflicts have global consequences. During the 2018-2019 U.S.-China trade war, it was not only the yuan and the dollar that moved. Currencies in countries such as South Korea, Mexico, and Thailand also responded—despite not being directly involved.

The authors show how such shocks cascade through the trade imbalance network, influencing investor behavior and altering currency risk even in places far from the original dispute.

Implications for Investors and Policymakers

For central banks, finance ministries, and investors, the CBC offers a more nuanced view of currency risk, the authors say. It suggests that interconnectedness, not just imbalance size, plays a critical role. And it helps explain why countries facing similar trade gaps can see different currency outcomes.

The CBC also correlates with—but does not replicate—conventional risk metrics such as the VIX index or TED spread. It captures structural features of the global economy that these market-based gauges may overlook.

In a world where trade tensions flare unpredictably and supply chains are under strain, understanding how currencies respond requires more than bilateral thinking. This paper suggests that to grasp the movements of money, one must first follow the flows of goods—and trace the web they weave.