Some countries such as the United States and Britain run persistent trade deficits, while others such as China and Singapore run trade surpluses. Economist LINDA LIM explains the reasons for and implications of such these trends.

Trade Deficits

A country’s balance of trade refers to the difference between its exports and imports.  When imports exceed exports, the country has a deficit. When exports exceed imports, it has a surplus.

Trade when used here refers to “merchandise trade” in goods.  A more complete measure of the overall trading relationships that a country has with other countries is the current account, which includes trade in services as well as goods.  A small Caribbean island nation could have a merchandise trade deficit because it imports most of what it consumes (food, energy, manufactured goods), but still have a current account surplus, if its surplus in the export of services (like tourism) exceeds the goods deficit.  Similarly, the U.S. has a large merchandise trade deficit, but a surplus in trade in services like financial and business services, and intellectual property. This explanatory note will discuss the trade rather than the current account balance, but the same analysis applies to both.

Countries trade on the basis of comparative and competitive advantage. They export what they can produce more efficiently – cheaper, faster, better – than their trade partners.  This is usually based on the amount and type of resources found within a country.  For example, Cambodia is a competitive exporter of apparel, because apparel manufacture is labor intensive and Cambodia has a lot of cheap labor relative to other resources and other countries.  The U.S. is a competitive exporter of aircraft, because aircraft manufacture is intensive in the use of capital and skills, and the U.S. has a lot of capital and skilled labor compared to other resources and other countries. 

Within a country, firms use scarce resources to make the products in which they are competitive, which will earn them higher profits.  So the U.S., for example, specializes in aircraft production and exports planes, while importing apparel from Cambodia, which specializes in exporting apparel and imports planes.  Because Cambodia is a small, poor country, it cannot in a year buy as much in planes as the big, rich U.S. can buy in apparel.  The result is a bilateral trade surplus for Cambodia with the U.S., and a bilateral deficit for the U.S. with Cambodia.  This trade imbalance reflects market forces, rather than unfair trade practices on the part of either country.

A country will typically have bilateral trade deficits with some countries and surpluses with others, depending on the size and composition of what they exchange with each other. Thus the U.S. has a trade deficit with Cambodia and Vietnam, but a trade (or current account) surplus with Singapore and Australia. Overall, and over time, if driven by market forces, a country’s global current account balance will tend towards zero.

This happens through exchange rate movements.  If a country runs a persistent trade deficit, this means its residents have (relatively) strong demand for foreign goods (and for the foreign currency with which to buy them), while foreigners have weak demand for its goods (and for the currency with which to buy them).  The home currency will then weaken against the foreign currency, making home goods (exports) cheaper abroad, and foreign goods (imports) more expensive at home.  Exports will increase and imports fall until the trade deficit is eliminated.

Conversely, where a country has a persistent trade surplus, its currency will strengthen. This causes its exports to fall as they become more expensive for foreigners, while its imports increase as they become cheaper for home consumers. Eventually, in this way, the trade surplus is eliminated.

Why, then, do some countries run persistent trade deficits (U.S., U.K.), while others run persistent trade surpluses (China, Germany, Singapore)?   A country runs a persistent deficit because the inflow of foreign capital through loans and investment creates demand for its currency, preventing it from falling.  By definition, a trade deficit means a country must be a net recipient of foreign capital – a relationship expressed in the rule, “a current account deficit equals a capital account surplus.” The country pays for excess imports (a trade deficit) by borrowing from abroad or selling domestic assets to foreign investors, yielding a capital surplus (more capital entering than leaving the country).

The U.S. is particularly able to run a persistent large trade deficit because other countries are willing to hold U.S. dollars and dollar assets as both a medium of exchange and a store of value. Other countries treat the dollar as a de facto “reserve currency” because of their confidence in the size, liquidity, diversity, security and governance of U.S. financial markets, and their belief in the strong growth potential of the U.S. economy.  Former U.S. President Ronald Reagan noted that the U.S. trade deficit in the 1980s was a sign of a strong economy, not a weak one. Foreign capital inflow to acquire U.S. assets keeps the dollar strong and growth high, perpetuating the trade deficit.

The trade deficit will fall only if some or all of the following happen: consumers reduce their consumption, businesses reduce investment, and/or the government reduces the budget deficit (by raising taxes and cutting spending).  The resultant slowdown will reduce imports. It may also increase exports if demand for domestic goods falls so much that businesses cannot sell them at home but must find foreign markets.  Import barriers like tariffs can contribute to this process by taxing consumers and reducing consumption.  At an extreme, such an adjustment can lead to a recession.  A slowdown will also discourage foreign capital inflow, thereby weakening the currency, making imports more expensive and exports cheaper. This in turn tends to narrow the trade deficit.

A country with a trade surplus exports capital by lending or investing its excess foreign exchange earnings abroad – summed up as “a current account surplus equals a capital account deficit”.  Exporting capital – selling home currency to buy the foreign currency required to buy foreign assets — prevents the home currency from strengthening.  This in turn keeps exports “competitive” (cheap) and imports expensive, so is sometimes referred to as “currency manipulation” to preserve a surplus.

Import barriers are not the main cause of a trade surplus. Rather, a trade surplus is the result of weak domestic demand, when savings are too high and/or the government runs a budget surplus.  For a country to import more and export less requires an increase in domestic consumption, lower taxes and/or higher government spending. 

China has the world’s largest national trade surplus in part because its growth  has been relatively weak in recent years, so its demand for both foreign and domestic goods is likewise relatively weak.   To increase growth, its government is now trying to boost domestic consumption (currently at only 55% of GDP, compared with 70% in the U.S.) and provide fiscal and monetary stimulus through increased government spending and lower taxes and interest rates.  It could also stop managing (or “manipulating”) the yuan – to date it has been keeping it low to cheapen exports and yield a trade surplus. If China sells foreign assets it has accumulated over years of surpluses, this will strengthen the yuan, while the currencies of other countries would become weak. These changes would have the effect of making exports more expensive and imports cheaper, thus shrinking China’s trade surplus.

– By LINDA LIM, Professor Emerita, Stephen M. Ross School of Business, University of Michigan.