Last Updated on March 11, 2021 by Filip Poutintsev
A trade deficit is an amount by which the cost of a country’s imports exceeds its exports. It’s one way of measuring international trade. A trade deficit occurs when a country buys more goods and services than it sells abroad. Balance of Trade (BOT), also known as trade balance, is the difference between the country’s imports and exports. A negative trade balance indicates a trade deficit.
Trade deficit usually occurs when the country is unable to produce or provide everything required by its citizens and borrows from foreign countries. It causes an outflow of domestic currency to foreign markets. Money flowing out to pay for imports has a vital effect on the country’s economy. The country spends more money on imports than it makes in exports that create an imbalance between the country’s saving and investments.
A trade deficit does not necessarily mean money is flowing out of a country. A country running a large current account deficit will have money coming in through a capital inflow (investments). It means money comes in one way and goes out another way. A trade deficit can only turn into surplus when exports rise and import falls.
Trade Deficit = Total Value of Imports – Total Value of Exports
Let’s take an example to understand the trade deficit in an easier way. Let’s say a country imports goods worth 2 million USD. At the same time, it exports 1 million USD worth of goods. We can see the difference between export and import as import exceeds export by 1 million, which indicates a trade deficit.
The U.S. holds the distinction of having the world’s largest trade deficit since 1975. In 2019, the U.S. trade deficit was $616.8 billion according to the U.S. Bureau of Economic Analysis. The US, UK, India, France, and Hong Kong are the top 5 countries with the highest trade deficit worldwide in 2018.
A trade deficit is neither inherently entirely good nor bad. Initially, a trade deficit is not necessarily a bad thing. But over time, a trade deficit has effects on the economy which are outsourcing jobs and falling economy. Whether trade deficits are good or bad for an economy? Let’s go through some of the pros and cons of the trade deficit:
Table of Contents
Pros of Trade Deficit
1. Improves Living Standard
Trade deficit may increase the standards of living of the people by making the availability of a variety of products through import which they are not able to produce in the domestic market. A country can have access to goods and services for a very competitive price.
A country is able to import useful goods and services in exchange for pieces of paper i.e. money. Trade deficit allows a country to consume more than it produces. Also, trade deficits can help nations to avoid shortages of goods as they can be imported from other nations.
2. Comparative Gain
A country has a comparative benefit when it can produce a product or service more cheaply than others. For example, country A specializes in producing cars because it is cheaper to do so. But country B specializes in producing mobile phones for the same reason.
Specialization with trade allows both countries to buy more cars and more mobile phones. Economic research has shown that when countries trade with each other, global wealth increases and all countries are benefitted.
3. Foreign Investment
One of the benefits of the trade deficit is that the country attracts large capital inflows, especially in the form of foreign direct investment (FDI). Money flowing out to pay for imports flows back in to help pay for productive investment in new capital. Let’s take an example of the United States.
In 2019, Americans bought about the US $616 billion more goods and services from abroad than foreigners purchased from the U.S. But foreigners sent about that amount right back to the U.S. to help American businesses build infrastructures/factories, create jobs and increase growth.
Cons of Trade Deficit
1. Harmful for Developing Countries
Usually, a developing country puts efforts for boosting its domestic market & industries and focuses on export rather than an import. If the country imports more and more just to fulfil the citizen’s demand and their standard of living, it would lead to deflation of economy and fiscal deflect.
The domestic products must compete with the imported ones and would need to lower the price. Even doing this will not help the domestic market to survive because of the high popularity of foreign products.
Trade deficit happens when goods are brought from other countries or imported instead of the domestic market. This forces domestic business or industries to shrink that causes a decrease in domestic jobs. The reason behind the fall of job opportunities is the decrease in the use of domestic goods.
G.D.P. measures the value of goods and services produced within a country’s borders, so when a country is selling less stuff abroad than it buys from abroad, the country is making less stuff, and as a result, there are fewer jobs. In the short term, a trade deficit is not bad but sustained deficits will have serious effects on domestic employment.
3. Leads to Foreign Ownership
If a country continually runs trade deficits, citizens of other countries acquire funds to buy up capital in that nation. Though it attracts foreign investments that increase productivity and create jobs, it also has some negative effects on the country. It may also involve merely buying up existing businesses, natural resources, and other assets. If this buying continues, foreign investors will eventually own nearly everything in the country.
4. Reduction in Currency Value
Trade deficits lead to a lowering in the value of the currency compared to foreign currencies. This raises the costs of imported goods and causes inflation. Due to trade deficit domestic currency flows to foreign markets, which results in a decrease in currency value in the world market.
On the other hand, when a country sells exports, it also exchanges payments made in foreign currency back into the domestic money and strengthens domestic currency. This makes the domestic currency stronger. To conclude, in the long run, trade deficits may be expected to contribute to a weaker currency, as the economy adjusts to create the surpluses needed to repay foreign investors.
A nation with a trade deficit spends more on imports than it makes on its exports. Trade deficits can be a problem when those deficits are due to government borrowing in countries with weak economic and political institutions. But for well-functioning economies like the U.S., trade deficits are not an inherent problem because there are other economic surpluses into the economy of a country.
Trade deficits are no guarantee of economic weakness. Trade deficits are not harmful because it gets balanced out in the end because the currency will always come back to the country in some form or another. Trade deficits can work out well or poorly, depending on whether the corresponding flows of financial capital are wisely invested.