Price Elasticity of Demand for Currency During Geopolitical Shocks

Among global financial markets, currency markets are one of the most sensitive to psychological factors. Currency exchange rates not only reflect the economic fundamentals of a nation's economy, but also reflect the collective expectations of the market regarding the direction of the economy and thus the currency's value. During times of geopolitical shock, expectations regarding exchange rates can change drastically in a matter of hours.

When considering the price elasticity of demand of currencies, we need to ask a very specific question: How much does the quantity demanded of a currency change in relation to changes in its price? And what happens to that price elasticity if suddenly the world's stability decreases significantly?

In ordinary circumstances, demand for currencies has a moderate level of price elasticity and stands to be affected by interest rate differentials, the volume of trade, and capital portfolio rebalancing, which will occur in a reasonably predictable relationship to changes in the currency exchange rates. In contrast, geopolitical shocks compress the time frame for which demand or supply is perceived and increase the volatility of the demand and/or supply; this creates a type of distortion of the normal relationship between currency price and quantity demanded; that is, the demand for safe-haven currencies will be highly inelastic and the demand for emerging-market currencies will be very elastic.

The Safe-Haven Effect refers to when capital floods into currencies that are considered to be safe-havens during times of heightened geopolitical risk, irrespective of the price at which those currencies are trading. The US dollar, Swiss franc, and the Japanese yen are three of the clearest examples of this Safe-Haven Effect. When the Russian invasion of Ukraine began on 24 February 2022, the DXY increased by 2% within just a few days, even though the Fed had not yet been signalling any upcoming interest rate hikes. Instead of evaluating the US dollar on the basis of yield, investors were purchasing it for the purpose of maintaining the value of their capital and assets. Very little price elasticity indicated that demand for the Swiss franc was relatively unchanged. Even with persistent efforts by the Swiss National Bank to limit the strength of the Swiss franc, demand for that currency remained strong. Market participants were willing to pay the cost of the currency, even though paying for it at its "normal" market price would have deterred them from making that purchase.

It is also evident that there is a clear need for a safe-haven currency in times of extreme uncertainty. As such, the utility value of a safe-haven asset is more significant than the cost associated with the currency's exchange rates. Meanwhile, the cost of keeping a risky asset is perceived by many as too steep; therefore, the demand for that asset will always be relatively inelastic.

The emergence or establishment of elastic demand patterns occurs frequently within emerging-market currencies. Following significant geopolitical shocks, for example, the Turkish lira depreciated more than 44% against the US dollar in 2022 while at the same time experiencing domestic political pressures and regional instabilities. The response of investors to these events demonstrated the extreme sensitivity of their behaviour to price signals. Although modest declines in currency values might seem immaterial, they may trigger additional capital outflows as a result of the self-fulfilling nature of holding currency-related costs.

Evidence of this same elasticity dynamic is well documented for various currencies throughout history. For example, many currencies (including the Indian rupee, the South African rand, and the Brazilian real) experienced extreme volatility and depreciation due to repatriation of capital back to the US during the 'taper tantrum' in 2013. This volatility occurred not as a result of direct geopolitical conflicts, but rather as a result of the shift in investor perceptions about risk.

While currency traders and investors will benefit from this increased elasticity, they should also understand how this same elasticity is applicable to their trades within the carry trade unwind strategy. Through the amplified effect of leveraged positions, the increased elasticity of demand for currencies during times of stress has been well established.

In addition to currency traders, the effects of currency collapses extend well beyond just those affected by the immediate collapse of their currencies. For example, as many of the world's nations purchase their oil and food using dollars, when currencies of emerging markets collapse, their import costs for energy and food increase substantially. The 2022 Sri Lanka foreign currency crisis — partially driven by the global commodity shock as a result of the Ukraine war — exemplifies how currency elasticity can cascade through the economy, negatively affecting its ability to import, raise prices, and sustain sovereign debt. Understanding these dynamics requires in-depth knowledge about forex trading and the behavioural responses of global currency markets.

As countries around the world become increasingly fragmented due to sanctions, trade blocs, and BRICS nations slowly de-dollarising, the ability of the world's nations to establish structural advantages through their currency structures will continue to diminish.