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Table of Contents
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- Trade and Investment Barriers
- A graph of US dollars in millions against years
- Factors Contributing to Global Trade Imbalance
- Saving Glut Hypothesis
- Bubble in Asset Prices
- Housing Market
- Consumption Boom
- Policy Making
- Military Spending
- Hedonistic Pricing
- Macroeconomic Conditions
- Tariffs and Quotas
- Market Forces
- Trade between Foreign Affiliates
- Is US Trade Balance Sustainable?
- Related Economics essays
America’s trade imbalance increased since the year 1991 and hit a gross domestic product of about 6% in 2006, but later in 2007 it began to drop and hit a low of 3% in the year 2009. Economists have always questioned whether the current account deficit, which is mainly financed by capital inflows, is sustainable. This is because, a GDP as low as 3% might be extremely large to be sustained permanently. This is as a result of the recession. In addition, these economists are concerned about the fact that a huge sum of capital inflow comes other countries' central banks hence might have some political and economic impacts on the US. They considerably fear that a rise in the interest rate may happen as a result of fall in the amount of capital inflow from other countries, which will cause the US dollar to depreciate in value. This will eventually cause the tradable assets in the US market to lose value and, therefore, interfering with the economic activity. However, since production of goods for trading will be hastened by this, empirical evidence and even economic theory has continually mentioned that this may not significantly affect the level of economic activity but might slightly cause the current account deficit to fall. Deficit in CA create trade imbalance.. This paper looks at some of the causes of the trade imbalance in the US and other factors that contribute to global trade imbalance.
Trade imbalance or balance of trade refers to the difference between money received from a country’s exports and that spent on its imports over a certain time. An economy’s balance of trade can either be positive or negative. When a nation has more exports than imports, it records a positive balance of trade. This results to a trade surplus. On the other hand, a negative balance of trade occurs when a country’s imports are more than its exports resulting in a trade deficit. The trade deficit created as a result of a country importing more than what it exports results in a trade imbalance. Trade deficits over a short period are usually not viewed as threats to a country’s economy as this is a normal economic behavior. However, if this deficit in an economy prevails for a long time, then it becomes a threat to the economic performance of a country. A country’s balance of trade is hard to predict because of its dynamism depending on whether an economy is of domestic demand led growth or export led growth. This will help to know at what level of the business cycle the trade balance will worsen or be favorable.
Global Trade Imbalance in U.S (Statistical Artifact)
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China Factor – Currency Manipulation;
Currency manipulation is one of the major cause of the main causes of the growing trade deficit between the US and China. China does not allow its Yuan to fluctuate freely against the dollar like other countries' currencies. Instead, it has its currency pegged tightly to the US dollar at a rate that makes it have an immense bilateral surplus with the US. Normally, when the output of China in relation to its input declines, the value of the Yuan should increase to adapt to this. However, this is not the case since the value of the Yuan has continually remained low. This is because when this happens, China purchases a great number of the US dollars and foreign exchange from other countries to make the value of its currency to stay as low as possible. For example, between the year 2009 and 2010, China made itself purchase US securities including treasury bills worth 450 billion US dollars so that it could be able to maintain its peg against the US currency. This practice makes the Chinese Yuan relatively cheaper as compared to the US dollar. This makes Chinese exports relatively cheaper as compared to those from the US.
The best estimates place this effective subsidy at roughly 28.5% of the U.S. dollar, even after recent appreciation in the Yuan (Cline and Williamson, 2011). This equally raises the cost of export of goods from the US to China and to the rest of the world, especially the third world countries. It, therefore, makes goods from the US less competitive not only in the Chinese market, but also in every other market where Chinese goods have to compete with goods from the US market. This practice has made China the most significant competitor of the US, more than any other member of the European Union. Other third world nations have equally imitated China's currency manipulation practice. This is to enhance their competitiveness in the world market and to expand the amount of their exports. This will allow their economies to grow. This has caused the US economy to suffer a global trade imbalance hence hurting its economic growth process.
According to Cline and Williamson (2011) to reduce the U.S. current account deficit to 3.0% of GDP in 2016 (from a projected 4.6% if the US does not realign its currencies), the Yuan needs to rise 28.5% against the U.S. dollar, and currencies from the other four Asian countries listed need to rise by 27.5% to 38.5% against the dollar. They project that global currency realignment (a rise in value of the five Asian currencies discussed here as well as coordinated shifts in the values of other currencies) would result in an 8.5% fall, in the trade-weighted value of the U.S. dollar across all currencies. This will help to reduce the rising trade imbalance to low and manageable levels.
Trade and Investment Barriers
Rising foreign direct investment in the US during the 1980s has increased the number of importance of US affiliates of foreign firms. Specifically, large investment inflows have made these affiliates principal sources of improved industry competitiveness. In the long run, presence of foreign owned firms may strengthen the international trade position of the US hence improving the balance of trade. Production in US affiliates of foreign multinational corporations could potentially displace imports from either foreign parent companies or other foreign suppliers. The supply side effects of foreign direct investment like transfer of technology could expand US exports hence trade balance. On the other hand, the trade deficit of the US relative to that of China increased from 84 billion US dollars in 2001 to 278 billion dollars in 2010. This was because of Chinese practices like currency manipulation, dumping, high subsidies and imposing both legal and illegal trade barriers. The trade deficit with China has, therefore, risen to this extent. This is further attributed to the rise in the amount of foreign direct investment in China and also the rapid expansion of other sectors like manufacturing. In addition, there has been the absence of a growing market for U.S. consumer goods in China and the rest of the world.
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GRAPH: Current account balance as a percentage of U.S GDP between 2000 and 2011.
From the graph above, the Current Account in the United States was last reported at -3.2 percent of GDP in 2011. From 1980 until 2010, the mean current account as a percentage of the gross domestic product started at a low of -2.67% and hit a high of 0.20% in December 1981. However, it went further down in 2006 and recorded -6.00%. A strong current account signifies that the output of an economy is high and hence its gross domestic product automatically expands as a result of increased earnings from exports. When potential investors speculate that the interest of the US will rise, they increase their increase their investment in the US. This increases demand for the dollar causing the exchange rate to appreciate in value. However, when the current account to GDP ratio is higher than normal, the general price level of commodities will shoot up leading to inflation in the economy. This will make United States products less competitive when sold abroad as compared to other countries' goods.
GRAPH: U.S balance of trade (1995-2011)
A graph of US dollars in millions against years
The negative figures denote negative balance of trade (trade imbalance). From the graph, it is clear that the US had a trade imbalance from earlier years, which extended to 1995. The trade deficit increased at an extremely high increasing rate from 1997 as seen above. It is highest in 2005 where the trade deficit is 817.3 billion dollars, up from 767.5 billion dollars in 2004.
Factors Contributing to Global Trade Imbalance
Several factors contribute to global trade imbalance. These factors are discussed below:
Saving Glut Hypothesis
As explained by Bernanke, in relation to the year 1995, suppose the whole world discovered that the US market was a perfect place to invest their money. They will desire to buy US securities including bonds and stock. To do this, they will need US dollars. This raises demand for the US dollar as compared to the currencies of other countries. This in turn, has made local goods expensive to US consumers. Being rational, these consumers will prefer to purchase foreign goods. This causes the current account to move to a deficit because of increased demand for imports while the capital account moves to surplus because of the increase in foreign investment, in the US, in bonds and stocks. This creates an imbalance of trade in the US. Inside the US, consumption increases more than savings. This leads to a trade deficit.
Bubble in Asset Prices
A bubble in asset prices refers to a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers, speculators interested in profits from trading in the asset rather than its use or earnings capacity (Eatwell et al.,1987). This leads to a trade imbalance when the bubble eventually bursts. This is because of the presence of many overvalued commodities in the market which slows down economic activities. This effect was seen in the early 1970’s in the US, where there was excess monetary expansion that caused the U.S Central Bank to intervene by raising interest rates.
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The domestic monetary and housing price shocks can also contribute to explain the movement of the U.S. trade, balance through the real estate credit channel. Because of households’ imperfect access to financial markets, real estate price changes generate a collateral effect which induces consumption to positively commove with house price; as a consequence, the trade balance moves towards a deficit. A positive (negative) change in real estate prices the trade balance moves towards deficit (surplus): higher (lower) values of houses, used as collateral in financial transactions, allow higher (lower) borrowing and hence higher (lower) consumption and imports. Previous studies show that in the aftermath of a positive housing price shock, the increase in the trade deficit is higher for higher values of the landfall ratio. In addition, exchange rate depreciation limits the size of the external deficit when the degree of pass-through of nominal exchange rate into import prices is, counterfactually, high.
Consumption boom is another factor that can cause a trade imbalance in a country. When consumers' demand for commodities increases as a result of increase in their income, this is associated with an equal increase in the price of the respective commodities. This may further increase to undesirable levels causing inflation to occur and at the same time increasing demand for foreign goods. This causes a trade imbalance in a country' economy. For example, the deterioration of the US merchandise trade deficit in the 1980’s fell mostly on durable goods. Therefore, a decrease in intertemporal prices associated, for example, with exchange rate over-valuation worsens the trade balance in durables more than nondurable goods.
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Policy making is a significant factor when it comes to trade imbalance. It is necessary to have policies regulating trade within and outside a country. This helps to bring order in the trading process and enhances a common understanding among trading partners. This will help to eliminate unwanted practices, which could result to trade imbalances.
Increased military spending leads to increased unemployment and also slows the rate of growth of output. Military spending represents a net drain on the balance of payments of a country. This forces the government to follow more restrictive policies so as to hold down inflation and adjust the competitive position of the country in world trade. However, military spending to manufacture ammunitions for export leads to a positive balance of trade. Military spending effect was seen in the US in 1973 where overseas arms sales were more than imports.
Hedonistic pricing method is used to estimate the economic worth of either environmental services or ecosystems which affect the market prices directly. This has been previously stated as a cause to nation' trade imbalance. This is because this pricing method has its own limitations that make it undesirable. For example, the extent of environmental benefits that can be quantified and, therefore, measurement is only limited to things associated with prices of housing and the fact that this method does not reflect all consumer attributes apart from factors like the consumers' willingness to pay for the differences that they believe exists in environmental characteristics. Use of hedonic pricing leads to an undesirable trade imbalance because of these factors.
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These are the external conditions that affect other economic variables. They include prices, interest rates and exchange rates among others. Unfavorable macroeconomic conditions like inflation, low interest rates and weak currencies result to balance of trade imbalance. This is because they have associated negative effects on the economy like inflation and massive capital outflow.
Tariffs and Quotas
These are restrictions to international trade. Presence of tariffs and quotas on a country’s imports can help to protect it from dumping, negative balance of payment and other negative factors that would result in trade imbalance. When a country relaxes its restrictions on trade like tariffs and quotas that had initially been put in place, it opens its economy to the rest of the world and risks importing market imperfections, which will result in trade imbalance.
Market forces of demand and supply can also play a role in creating trade imbalance in a country. For example, consumers’ demand for a commodity may rise causing prices also to go up. Without government intervention, this may continue leading to inflation which causes a trade imbalance to occur since a country’s goods will be less competitive in the international market. Therefore, regulations have to be devised to help control this imbalance.
Trade between Foreign Affiliates
Trade between foreign affiliates can result in a trade imbalance in the country of trade. This is because these affiliates’ economic environments are from a different country and their rate of business activity is different from the host nation. Therefore, these practices may result in a trade imbalance in the host nation.
Is US Trade Balance Sustainable?
In the long run, running a CA deficit at the current trend levels (i.e., growing faster than GDP) would result in net foreign debt continually growing relative to GDP. This is unsustainable if foreigners have a limited appetite for U.S. assets. Thus, in the long run, the CA deficit will most likely decline, although it needs not decline to zero to stabilize the net foreign debt relative to GDP.
Relative to GDP, the CA deficit is declined by about half between 2007 and 2009. It is too soon to say whether this decline has been caused by temporary, cyclical factors or represents the beginning of a long-term adjustment, process. To date, the net foreign debt has placed no burden on the U.S. economy because U.S. owned foreign assets have earned more than foreign-owned U.S. assets.
Whether policy makers should be concerned about a future decline in the current account deficit depends on whether the declines were to happen in an orderly or disruptive way. There is little reason to think that a gradual decline would have a deleterious effect on the overall economy. But, a sudden decline, brought on by a sudden reduction in foreign capital inflows, could be disruptive to U.S. financial markets, causing negative spillover effects for the broader economy. While a sudden reduction in foreign capital inflows cannot be ruled out—it has happened to foreign countries – it seems highly unlikely. The United States is different in a number of ways from the countries that have experienced CA crises, its financial markets and economy are highly developed, it has a floating exchange rate, and it is seen as a haven in times of financial turmoil. Nonetheless, even if the risk of a sudden current account reversal is small, it is arguably worth policy consideration since it could be highly costly to the U.S. economy.
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The rising trade deficit of the US with China has resulted to several people losing their jobs in the United States and this significantly contributed to the crisis in the U.S. manufacturing employment. This was because most of the manufactured goods from the US lost their international market to China and also other third world countries that emulate China. This has increased tremendously in the past decade because of increased trade with China. In addition, the United States is increasing its foreign debt while at the same time losing export capacity, and hence facing a more fragile macroeconomic environment. The recent financial crisis in the United States is similar to the scenario envisioned by economists concerned about a sudden, destabilizing outflow of capital.
When the crisis worsened in September 2008, the dollar began appreciating and, increasing demand for certain U.S. assets, such as U.S. Treasuries, drove their prices up to unusually high levels. However, a large and potentially destabilizing net withdrawal of private, foreign capital in 2008 and 2009 was offset by official capital net inflows (primarily purchase of U.S. assets by foreign governments). Therefore, considering all these, proper measures should be devised to ensure a balance of trade in the US economy.