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Trade deficit: What is it all about?

Muhammad Mahmood | Published: May 27, 2017 21:19:18 | Updated: October 22, 2017 10:08:07


There is a general perception that a trade deficit or, more precisely, a current account deficit is harmful to a country and quite often such a view is also reinforced by the media and politicians. There are even accusations of foul play by foreign powers to cause economic harm to the nation by pushing the economy towards running trade deficits. We have seen plenty of that already coming from President Trump and his economic advisers and also from his commerce secretary. But the counter-narrative tells us that the deficit enables more investment than would have been possible otherwise. Since higher investment leads to higher growth and higher living standards, capital inflow resulting from current account deficits is beneficial to the economy.  This also coveys an implicit vote of confidence by foreign lenders. 
We must, however, keep it in mind that a trade deficit is not a good indicator of a country's economic performance. The current account is the broadest measure of a country's trade balance. It includes trade in goods (balance of trade), services (balance on services) and together they constitute balance on goods and services.  In addition, the current account also includes net unilateral transfers (e.g. workers remittances and foreign aid), and net investment incomes. They all together make up the balance on current account. The balance on trade in goods and services is often combined because they reflect real, as opposed to the financial, international transactions constituting what is more broadly described as exports and imports. A positive current account surplus indicates an excess of total exports over imports, and a deficit indicates an excess of imports. 
The deficit on trade in goods appears to be the major source of concern and debate, especially in the USA.  This has been happening more than three decades now. Under the current US administration, there are concerted efforts to blame countries, such as China, Mexico and even Germany for the US trade deficits. The current account balance is net trade balance on goods and services, and net transfer payments.  And net investment income is equal to national saving minus domestic investment on the assumption that budget is balanced. This is an accounting identity, thus true by definition. Anyone interested in this issue is well advised to memorise this because it summarises the important relationship between the current account balance, investment and national saving (private+ public) in the economy. Therefore, a current account deficit is caused by investment exceeding national saving and exactly the opposite happens if there a current account surplus. If total savings remain unchanged while investment increases, the current account deficit will plunge further into a deeper deficit. According to the identity specified above, if government budgets are in deficit, total national saving is further reduced and other things being equal, investment will correspondingly fall and a budget surplus augments private savings, thereby increasing investment.
Current account deficits must be financed by international capital inflows. That in practical terms means a country like the USA experiencing current account deficits must have to borrow externally and countries like China, Germany, Japan and the Netherlands, who run current account surpluses, are in a position to lend to the USA. The USA settles its deficit by paying in dollars and creditor countries then buy US Treasury Bonds, thus dollar flowing back to the USA -- as if the  money never left the USA. As for the Federal Reserve, it only needs to print or use other means to create correct amount of the dollar and pay up the creditor if they want to cash in those bonds. 
Almost all monetary authorities around the world hold foreign exchange assets mostly in the US dollar-denominated assets (mostly US Treasury bonds). This is the principal source which finances the US trade deficits.  This is what the French economist Jacques Rueff famously remarked   about the whole process as "deficit without tears". The US dollar is also used as the invoicing currency in trade transactions for goods and services when neither party is located in the USA. This gives the US dollar the status of a vehicle currency further adding to demand for it. As long as the US consumes more than it produces, the deficit will persist and to understand that one has to find out the reasons for the low level of national saving. Therefore reducing the deficit will necessarily require a higher rate of national saving.
In the case of developing countries like Bangladesh there is no scope for a current account deficit without tears as their trade deficits are financed through inflows of financial capital. Capital inflows can take different forms such as foreign direct investment (FDI) to purchase of stocks and bonds and loans. Loans add to country's stock of external debt requiring debt servicing which involves interest payment and repayment of the principal. Foreign loans are not any different from other types of debt so long borrowed funds are used to enhance countries' productive capacity. An expansion of the productive capacity of the economy will enable the country to repay the external debt.
There is a variety of reasons that contribute to a current account deficit of developing countries.  Many developing countries are dependent on exporting one or two primary commodities, or even one or two manufactured products and they can experience a drop in their export prices in the case of primary commodities and decreased demand for manufactured goods due to economic slowdown in the major export markets, thus generating current account deficits. Some developing countries like Bangladesh also experience natural disasters like flood, cyclones or earthquake requiring foreign assistance. Corruption also plays a major role as exemplified in  illegal capital flights from Bangladesh, amounting to US$75.84 billion over a  10-year period from 2005 to 2014 (the Financial Express, in its issue of May 03, 2017). These illegal outflows of money averaging US$7.58 billion a year was done via trade transactions by manipulating trade documents.  
While developed countries like the USA and many others run current account deficits, some developing countries run current account surpluses or very near surpluses. In fiscal year (FY) 2014-15, Bangladesh recorded deficits in trade in merchandise and services of US$ 5879 million and US$5470 million respectively but unilateral transfers and investment incomes had a surplus US$1518.94 million of which workers' remittances constituted 95.4 per cent.  The overall current account balance for FY 2015-16 recorded a surplus of US$3706 million. This is rather the pattern for most of the years over the last decade or so for Bangladesh. 
It appears in the case of Bangladesh, the other component of the current account unilateral transfers and income contributed this to surplus than the balance on good and services which ran a deficit in the 2014-15.  A current account surplus increases Bangladesh's net foreign assets by the amount of surplus. Therefore, overall it indicates savings surplus over investment or a savings glut. With consistent current account surpluses, Bangladesh has been able to prevent any substantial depreciation of the currency; in effect, these surpluses may create an upward pressure on the currency. But empirical evidence suggest that large current account surpluses exhibit very little persistence over time as  can be seen in  the current account balance for the period between July, 2016 and February, 2017 where a deficit of U$1116 million was recorded. But in a country like Bangladesh, which is prone to natural disasters, current account surpluses will also work as a precautionary saving. 
The writer is an independent economic and political analyst.
muhammad.mahmood47@gmail.com

 

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