The relationship between U.S. trade deficit and dollar depreciation

U.S. Trade Balance & Exchange Rate

US Trade Balance and Exchange Rate

Most economists agree that there is a definite relationship between trade balance and the exchange rate. It is a general rule of economics that a negative trade balance (or trade deficit) normally leads to a weaker currency, and a positive trade balance (or trade surplus) results in enhanced value of the currency, although there are exceptions to the rule as several other factors may prevent such weakness or strength. The issue of trade balance and its effect on exchange rate of the country's currency is currently in the limelight because of the burgeoning U.S. trade deficit and the declining value of the U.S. dollar against some of the major world currencies. In this paper, I shall discuss the relationship between trade balance and exchange rate with particular reference to the United States besides exploring the other implication of the U.S. consistently running a trade balance deficit and suggesting some solutions to the deficit dilemma.

What is Trade Balance?

In economics, trade balance refers to the value of all the goods and services a country sells to other countries (its exports) minus the value of all the goods and services it buys from other countries (its imports). A positive balance of trade is called a trade surplus and a negative balance of trade is trade deficit. Neither condition is necessarily bad, but a large, persistent (and rising) trade deficit such as being experienced by the United States during the last several years could be a sign of economic problems. Even a positive trade balance, which at first sight seems desirable, may not always be so, as exemplified by Japan in the 1990s. The trade balance is reflected in the balance of payments account that has two heads: a) the current account, which monitors all trade activities -- the export and import, income from investments abroad, and money paid to foreign investors; and b) the capital account, which tracks the loans given to foreign countries and the loans received. (Ruby, 2003)

What is a Reserve Currency?

When people have confidence in the value of a currency, i.e., it is perceived to be relatively stable over the long-term and is supported by a large economy, open and deep financial markets, and low inflation, it assumes the status of the reserve currency. Such currency is held in significant quantities by other governments and institutions as part of their foreign exchange reserves. The U.S. dollar has held the status of the world's reserve currency after the Second World War. Hence countries that are running large trade surpluses such as China and Japan use their 'surplus' funds to purchase U.S. Treasury Notes, allowing the United States to export its paper (the dollar) to get real goods and services in return. Another factor that enable the U.S. To keep running such large trade deficits is that oil is priced in the reserve currency (the U.S. dollars) that compels many nations (and several institutions) to hold some of their reserves in U.S. dollars to hedge against the volatile price of oil. ("Balance of Trade," 2005) the status of the dollar as the sole reserve currency in the world has yielded significant economic benefits for America, by enabling it to pay for imports and borrow in domestic currency and at low interest costs.

Can the U.S. Dollar Retain its 'Reserve Currency' Status for Long?

The key question is, can the U.S. dollar retain its status of the resrve currency for long? History suggests that it may not. Before the advent of the dollar as the world's reserve currency, the British Pound had enjoyed such a status. Between the two World Wars and the post-World War II period saw the weakeing of the British economy. As a result, the British Pound was devalued by 30% in 1949, effectively ending its run as the world's reserve currency and the start of the dollar's reign. Dollar has been able to retain its status as the reserve currency since it was relatively stable, was backed up by the formidable economy of the U.S., low interest rates and the absence of an alternative currency. (Mann 1999, p. 56) Recent events including erosion in the value of the dollar, weaknesses in the U.S. economy, persistant high levels of trade deficit, and the availability of an alternate currency -- the euro, indicate that the dollar too may be approaching the end of its long run as the reserve currency.

Is the U.S. Trade Deficit Sustainable?

Some economists, including the U.S. treasury officials, contend that the U.S. trade deficit is nothing to be alarmed about as the country's economy and the U.S. dollar survived a similar slide in the late 1980s. This argument is hard to digest since the country's current-account deficit, currently running at close to 6% of GDP, is almost twice as big as at its peak in the late 1980s ("The Passing of the Buck?" 2004). Mooreover, while the U.S. was a net foreign creditor in the 1980s, at the end of 2004 its net foreign liabilities stood at $3.3 trillion dollars, or 28% of the GDP.

The optimists dismiss the alarm at the trade deficit by arguing that the large deficit is a sign of America's economic might and the direct result of a capital accounts surplus funded by investors queing up to invest in the U.S. And to lend it money. Such optimism, again seems misplaced because unlike the 1990s when large investments were being made in U.S. equity markets by private investors, the current account deficit is now being supported largely by the foreign central banks (especially Asian central banks) which are buying dollars to prevent their own currencies from appreciating and to support their own export-led growth despite the risk of future capital losses. According to Bank of International Settlements (BIS) estimates, central banks provided $441 billion of the $531 billion needed to finance the United States' 2003 current account deficit. (Roubini and Setser 2004, p. 4).

How long these central banks would be willing to continue holding dollars exclusively as their foreign exchange reserves and to continue financing the U.S. current account deficit is the trillion dollar question. Already, disturbing statements are beginning to emanate from some important players that the banks would like to diversify their foreign exchange holdings. Moreover, the scale of financing required from Asian central banks to sustain the exploding U.S. current account deficits in future would soon exceed the absorption capacity of Asian central banks. This is because current estimates indicate that central bank reserves would have to rise from the present $2.4 trillion to about $5 trillion dollars at the end of 2008 to support a rise in U.S. net external debt from $3.3 trillion to $7.4 trillion. (Ibid. 6) Continued financing of the U.S. trade deficits by the rest of the world is also not without its long-term problems: the U.S. would accumulate so much debt over time that the ultimate cost of adjustment would become too high for the U.S. economy. Hence, all indicators regarding the sustainability of the U.S. trade deficit are blinking red, despite the brave face that the Bush administration puts on the issue.

Is China the Source of the Deficit Problem?

The U.S. administration believes that the alleged under-valuation of the Chinese Yuan is the source of its deficit problems since there is a huge and growing trade imbalance between the U.S. exports and imports to China. The U.S. Senate recently passed a bill, threatening to slap a 27.5% tariff on Chinese imports if China does not revalue its currency within 180 days. ("Yuan Revaluation no help..." 2005) Most independent analysts as well as Chinese officials disagree with the contention that a revaluation of the Chinese currency would solve the U.S. deficit problem. China accounts for only 10% of the United State's total trade, so if there were a 10% revaluation of the Yuan, it would reduce the dollar's value by just 1%. ("Cock-a-Doodle Doo" 2005)

Possible Solutions to the Trade Deficit Problem fall in the value of the dollar is not enough for reducing the U.S. trade deficit sufficiently. The American government needs to borrow less by reducing its budget deficit and household savings in the U.S., which are among the lowest in the world, need to improve. The best way out according to most analysts is a gradual reduction in the U.S. trade deficit to sustain the U.S. And global growth rates. Roubini and Setser, in a recent paper, estimate that a measured reduction of the trade deficit by 0.5% annually would eliminate the deficit by 2015. (p. 6)

Conclusion general rule of economics holds that a persistent trade deficit results in depreciation in a country's currency. The U.S. has shown a persistent and rising trade deficit for the last several years, which has now reached alarming proportions. Although the U.S. economy and the dollar have been able to sustain the deficit due to status of the dollar as the sole global reserve currency and the need of export-oriented economies to support the American demand, strains are beginning to show. The dollar is losing value and the U.S. foreign debt is now almost 30% of its GDP. These are alarming signals for the U.S. And the world economies. Clearly, it is time to reverse the trend of the fast rising trade deficit by the adoption of appropriate policies.