A Multi-Country Evaluation of Trade Imbalances
 
Introduction: How to Evaluate Trade Imbalances



Table of Contents

Home
Introduction
United States
United Kingdom
Japan
Brazil
Venezuela
Mexico
Taiwan
Malaysia
Russia
Poland
Romania
Ghana
China
Conclusion

by Steven Suranovic
April 1999

A quick reading of business and financial newspapers and magazines often can reveal a number of misunderstandings about economic relationships. One of the most notable is the widespread conviction that trade deficits are a troubling economic condition which indicates weakness in an economy while trade surpluses are a sign of strength and rising prominence for an economy. Although these beliefs are well founded in some circumstances, they are not valid as a general principle. A careful look at the implications of trade imbalances reveals that trade deficits can, at times, be an indicator of rising economic strength, while trade surpluses can be a sign of economic disaster. In many other cases, perhaps most, trade imbalances are benign. That is, they do not represent a serious threat or indicate rising prominence.

There are several reasons why misunderstandings about trade imbalances persist. The first problem relates to the terminology. A deficit, regardless of what context applied, sounds bad. To say that a business' books are in deficit, that a government's budget is in deficit, or that a country's trade balance is in deficit, simply sounds bad. A surplus, in contrast, sounds good. For a business, clearly, we'd prefer a surplus ... to be in the black, ... to make a profit. Likewise a budget surplus or a trade surplus must be good as well. Balance seems either neutral or perhaps even the ideal condition. From an accountant's perspective, balance is often the goal. Debits must equal credits, the books must balance. Surely this terminology must contribute to the confusion, at least in a small way.

A second reason for misunderstandings, especially with regard to deficits, may be a sense of injustice or inequity because foreigners are unwilling to buy as many of our goods as we buy of theirs. Fairness would seem to require reciprocity in international exchanges and therefore balanced trade. This misunderstanding could be easily corrected if only people were aware that a country's balance of payments, which includes trade in goods, services and assets, is always in balance. There are no unequal exchanges even when a country runs a trade deficit.

A third reason for the misunderstanding is that trade deficits are indeed bad for some countries in some situations while surpluses have been beneficial for some countries. One need only note the many international debt crises experienced by countries after they had run persistent, and very large trade deficits. One could also look at the very high growth rates of Japan in the 1980s and China in the 1990s for examples of countries with large trade surpluses that have seemingly fared very well.

However, despite these examples, one should not conclude that any country that has a trade deficit or whose trade deficit is rising, is necessarily in a potentially dangerous situation. Nor, should we think that just because a country has a trade surplus, that it is necessarily economically healthy. To see why, we must recognize that trade imbalances represent more than just an imbalance in goods and services trade.

Any imbalance in goods and services trade implies an equal and opposite imbalance in asset trade. When a country runs a trade deficit (more properly labeled a current account deficit), it is also running a capital account surplus; similarly, a trade surplus corresponds to a capital account deficit. Imbalances on the capital account mean that a country is a net seller of international assets (if a capital account surplus) or a net buyer of international assets (if a capital account deficit). Assets come in two forms: debt and equity. The portion of a country's capital account imbalance in the form of debt, represents international borrowing (surplus) or lending (deficit). The portion of the imbalance in the form of equity represents either the purchase (deficit) or sale (surplus) of ownership shares in foreign and domestic businesses or properties.

One way to distinguish between good, bad or benign trade imbalances is to recognize the circumstances in which it is good, bad or benign to be an net international borrower or lender, or a net purchaser or seller of ownership shares in businesses and properties.

The purpose of this report is to study past trade imbalances for a group of countries over time and to evaluate whether their trade imbalance was good, bad or benign. The focus of the study will be on the international assets flows that accompany every trade imbalance, i.e., on the capital account. Macroeconomic trends for key variables will be compared with the trend in the trade imbalance to make the evaluation. Although it will impossible to conclude with certainty the character of each country's trade imbalance the results should at least be suggestive.

The next section presents criteria to be considered in making the evaluation for each country. This is followed by the individual country reports. The final section summarizes the country study reports and presents some observations about cross country comparisons.

II. What a Trade Imbalance Means

We define a variable called domestic spending (DS) as the sum of all domestic resident spending on consumption, investment, and government goods and services regardless of whether those products originated domestically or abroad. Simply stated, domestic spending is the value of the products that domestic households, businesses, and governments purchase during the year regardless of country of origin.

We can show the relationship between GDP and domestic spending by using the national income identity.(1)

GDP = C + I + G + EX - IM

Domestic spending is defined as DS = C + I + G therefore,

GDP = DS + (EX - IM)

When a country runs a trade deficit(2), (EX - IM) is negative which implies that domestic spending exceeds GDP. Thus, when a country runs a trade deficit, total expenditures on consumption, investment and government goods and services is greater than the total value of domestic production. More simply, the nation spends (and "consumes") more than it produces. Alternatively, the nation's total spending exceeds its income. To spend more than one's income requires either that the country borrows money, or, that it sells productive assets to finance the additional purchases. Thus, a trade deficit means that a country has borrowed more from foreigners than foreigners have borrowed from the country, and/or, that a country has sold more productive assets to foreigners than foreigners have sold to the country.

When a country runs a trade surplus, (EX - IM) is positive which implies that GDP exceeds domestic spending. This means that when a country runs a trade surplus, the total value of domestic production is greater than total expenditures on consumption, investment and government goods and services. More simply, the nation produces more than it spends. That is, the nation's income exceeds its total spending. When a country's income exceeds its spending either the country is lending the excess, or, it is purchasing productive assets from the rest of the world. Thus, a trade surplus may imply that a country has lent more to foreigners than foreigners have lent to the country, or, that a country has purchased more productive assets from foreigners than foreigners have purchased from the country.

In any case, a trade imbalance, whether a surplus or a deficit, corresponds to a net purchase or a net sale of foreign assets only during the year in question. The trade imbalance does not indicate whether the country has a net stock of external debt to the rest of the world or whether it has net external credits and thus is owed money by the rest of the world. It also does not indicate whether the country's net stock of foreign equities is positive or negative. As such the trade imbalance does not indicate the true "state" or condition of the economy. Instead one must look at the country's international investment position.

The International Investment Position

An evaluation of a country's trade imbalance should begin by identifying the country's net international asset position. The asset position is like a balance sheet in that it shows the total holdings of foreign assets by domestic residents and the total holdings of domestic assets by foreign residents at a point in time. In the IMF's financial statistics, these are listed as domestic assets (foreign assets held by domestic residents) and domestic liabilities (domestic assets owned by foreign residents). The capital account balance, whose counterpart is the current account balance, is more like an income statement which shows the changes in asset holdings during the past year. In other words, the international asset position of a country consists of stock variables while the capital account balance consists of flow variables.

A country's net international asset position may either be in surplus, deficit or balance. If in surplus then the value of foreign assets (debt and equity) held by domestic residents exceeds the value of domestic assets held by foreigners. Alternatively we could say that domestic assets exceeds domestic liabilities. This country would then be referred to as a creditor nation. If the reverse is true, so that domestic liabilities to foreigners exceed domestic assets, then the country would be called a debtor nation.

Asset holdings may consist of either debt obligations or equity claims. Debt consists of IOUs in which two parties sign a contract agreeing to an initial transfer of money from the lender to the borrower followed by a repayment according to an agreed schedule. The debt contract establishes an obligation for the borrower to repay principle and interest in the future. Equity claims represent ownership shares in potentially productive assets. Equity holdings do not establish obligations between parties, at least not in the form of guaranteed repayments. Once ownership in an asset is transferred from seller to buyer, all advantages and disadvantages of the asset are transferred as well.

Debt and equity obligations always pose several risks. The first risk with debt obligations is the risk of possible default (either total or partial). To the lender, default risk means that the IOU will not be repaid at all, that it will be repaid only in part, or, that it is repaid over a much longer period of time than originally contracted. The risk of default to the borrower is that future borrowing will likely become unavailable. The advantage of default to the borrower, of course, is that all of the borrowed money is not repaid. The second risk posed by debt is that the real value of the repayments may be different than expected. This can arise because of unexpected inflation or unexpected currency changes. Consider inflation first. If inflation is higher than expected, then the real value of debt repayment (if the nominal interest rate is fixed) will be lower than originally expected. This will be an advantage to the borrower, who repays less in real terms, and a disadvantage to the lender who receives less in real terms. If inflation turns out to be less than expected, then the advantages are reversed. Next consider currency fluctuations. Suppose a domestic resident, who receives income in the domestic currency, borrows foreign currency in the international market. If the domestic currency depreciates then the value of the repayments in domestic currency terms will rise even though the foreign currency repayment value remains the same. Thus, currency depreciations can be harmful to borrowers of foreign currency. A similar problem can arise for a lender. Suppose a domestic resident purchases foreign currency and then lends it to a foreign resident ( note this is the equivalent of saving money abroad). If the domestic currency appreciates then foreign savings, once cashed in, will purchase fewer domestic goods and the lender will lose.

The risk of equity purchases arises whenever the asset's rate of return is less than expected. This can happen for a number of different reasons. First, if the equity purchases are direct investment in a business then the return on that investment will depend on how well the business performs. If the market is vibrant and management is good then the investment will be profitable. Otherwise the rate of return on the investment could be negative. All of the risk, however, is borne by the investor. The same holds for stock purchases. Returns on stocks may be positive or negative but it is the purchaser who bears full responsibility for the return on the investment. Equity purchases can suffer from exchange rate risk as well. When foreign equities are purchased, their rate of return in terms of domestic currency will depend on the currency value. If the foreign currency in which assets are denominated, falls substantially in value then the value of those assets fall along with it.

III. Evaluation of Trade Imbalances

In general, there are four possible situations that a country might face in any particular year. It may be 1) a debtor nation with a trade deficit, 2) a debtor nation with a trade surplus, 3) a creditor nation with a trade deficit, or, 4) a creditor nation with a trade surplus. In Figure 1 below we present a number line depicting a range of international asset (or investment) positions. On the far left a country would be a net debtor nation while on the far right it would be a net creditor nation. A trade deficit or surplus run in a particular year will cause a change in the nation's asset position assuming there are no capital gains or losses on net foreign investments (more on that later). A trade deficit would generally cause a leftward movement in the nation's investment position implying either a reduction in its net creditor position or an increase in its net debtor position. A trade surplus would cause a rightward shift in a country's investment position implying either an increase in its net creditor position or a decrease in its net debtor position.

An exception to this rule occurs whenever there are changes in the market value of foreign assets and when the investment position is calculated using current market values rather than original cost. For example suppose that a country has balanced trade in a particular year and is a net creditor nation. If the investment position is evaluated using original cost then since the current account is balanced there would be no change in the investment position. However, if the investment position is evaluated at current market values, then the position can change even with balanced trade. In this case changes in the investment position arises due to capital gains or losses. Real estate or property valuations may change, portfolio investments in stock markets may rise or fall and currency value changes may also affect the values of national assets and liabilities.

Evaluation Procedures

The pros and cons of a national trade imbalance will in general depend upon which of the four situations describes the current condition the country. We shall consider each case in turn below.

Case 1) Net Debtor Nation Running a Current Account Deficit

This is perhaps the most common situation in the world or at least these are the cases which get the most attention. The main reason is that large trade deficits run persistently by countries that are also larger debtor nations will eventually be unsustainable. Examples of international debt crises are widespread. They include the third world debt crisis of the early 1980s, the Mexican crisis in the 1994, and the recent Asian crisis.

However, not all trade deficits nor all debtor countries face eventual default or severe economic adjustment. Indeed for some countries a net debtor position with current account deficits may be an ideal economic situation. To distinguish the good cases from the bad requires us to think about situations in which debt is good or bad.

As mentioned earlier, a current account deficit means that a country is able to spend more on goods and services than it produces during the year. The additional spending can result in either increases in consumption, investment and/or government spending. The country accomplishes this as a net debtor country by borrowing from the rest of the world (incurring debt), or by selling some of its productive assets (equities). A net international debt position means that the sum total of domestic resident liabilities to foreigners, in the form of debt and equities, exceeds the sum total of foreign assets held by domestic residents. A debt position arises by running net current account deficits (greater deficits than surpluses) over a country's history.

Let's consider a few scenarios.

First, suppose the current account deficit is financed by borrowing money from the rest of the world (i.e., incurring debt). Suppose the additional spending over income is on consumption and government goods and services. In this case, the advantage of the deficit is that the country is able to consume more private and public goods while it is running the deficit. This would enhance the nation's average standard of living during the period the deficit is run. The disadvantage is that the loans which finance the increase in the standard of living must be repaid in the future. During the repayment period the country would run a current account surplus resulting in national spending below national income. This might require a reduction in the country's average standard of living in the future.

This scenario is perhaps less troublesome if the choices are being made by private citizens. In this case individuals are freely choosing to trade off future consumption for current consumption. However, if the additional spending is primarily on government goods and services then the nation will be forced to repay government debt in the future by reducing its average living standards.

Possible reductions in future living standards can be mitigated or eliminated if the economy grows sufficiently fast. If national income is high enough in the future, then average living standards could still rise even after subtracting repayment of principle and interest. Thus, trade deficits are less worrisome the more rapid is economic growth currently and in the future.

One way to stimulate economic growth is by increasing spending on domestic investment. If the borrowed funds that result when a country runs a current account deficit are used for investment rather than consumption, or, if the government spending is on infrastructure, education, or other types of human and physical capital, then the prospects for economic growth are enhanced.

Indeed, for many less developed countries and countries in transition from a socialist to capitalist market, current account deficits represent potential salvation rather than a curse. Most poor countries suffer from low national savings rates (due to low income) and inadequate tax collection systems. The transition economies have a grossly outdated capital stock which desperately needs replacement. One obvious way to finance investment in these countries is by borrowing from developed countries who have much higher national savings rates. As long as the investments prove to be effective (a big if sometimes) much more rapid economic growth may be possible.

Thus, trade deficits for less developed and transition economies are not necessarily worrisome and may even be a sign of strength if they are accompanied by rising domestic investment and/or rising government expenditures on infrastructure.

The main problem with trade deficits arises when they result in a very large international debt position. It is this circumstance, it can lead to a crisis in the form of a default on international obligations. However, the international debt position figures include both debt and equities and only the debt can be defaulted on. Equities, or ownership shares, may yield positive or negative returns but do not represent the same type of contractual obligations. A country would never be forced to repay foreign security holders for their losses simply because their value on the market dropped. Thus, a proper evaluation of the potential for default should only look at the net international "debt" position after excluding the net position on equities.

Default becomes more likely the larger is the external debt relative to the countries' ability to repay. Ability to repay can be measured in several ways. First one can look at net debt relative to GDP. Since GDP measures annual national income, it represents the size of the pool from which repayment of principle and interest is drawn. The larger the pool the greater the ability of the country to repay. Alternatively, the lower is the country's net debt to GDP ratio, the greater the country's ability to repay.

A second method to evaluate ability to repay is to consider net debt as a percentage of exports of goods and services. This is especially relevant when international debt is denominated in foreign currencies. In this case, the primary method to acquire foreign currencies to make repayment of debt is through the export of goods and services. (The alternative method is to sell domestic assets) Thus, the potential for default may rise the larger is the country's ratio of net external debt to exports.

Notice though, that the variable to look at to evaluate the risk of default is the net debt position, NOT the trade deficit. The trade deficit merely reveals the change in the net debt position during the past year and does not record total outstanding obligations. Also a trade deficit can be run even while the net "debt" position falls. This could occur if the trade deficit is financed primarily with net equity sales rather than net debt obligations. Thus, the trade deficit, by itself, does not reveal the complete picture regarding the potential for default.

Next, we should consider what problems are associated with default. Interestingly it is not really default itself which is immediately problematic, but, the actions taken to avoid default. If default on international debt does occur, international relationships with creditor countries would generally suffer. Foreign banks who are not repaid on past loans will be reluctant to provide loans in the future. For a less developed country that needs foreign loans to finance productive investment, these funds may be cut off for a long period of time and thus negatively affect the country's prospects for economic growth. On the positive side, default is a benefit for the defaulting country in the short-run since it means that borrowed funds are not repaid. Thus the country enjoys the benefits of greater spending during the previous periods when trade deficits are run, but does not have to suffer the consequences of debt repayment. With regards to the country's international debt position, default would cause an immediate discrete reduction in the country's debt position.

The real problems arise when economic shocks occur which suddenly raises external obligations on principal and interest and makes a debt that was sustainable, suddenly unsustainable. In these cases it is the effort made to avoid default which is the true source of the problem.

Inability to repay foreign debt arises if either the value of payments suddenly increases or if the income used to finance those payments suddenly falls. Currency depreciations are a common way in which the value of repayments can suddenly rise. If foreign debt is denominated in foreign currency then a domestic currency depreciation implies an appreciation in the value of external debt. If the currency depreciation is large enough, a country may become suddenly unable to make interest and principal repayments. Note however, that if external debt is denominated in domestic currency then the depreciation would have no effect on the value of interest and principal repayments. This implies that countries with large external debts are in greater danger of default if their currency has, or may, experience rapid fluctuations and the larger is the external debt that is denominated in foreign currency.

A second way in which foreign interest obligations can suddenly rise is if the obligations have variable interest rates and if the interest rates suddenly rise. This was one of the problems faced by third world countries during the debt crisis in the early 1980s. Loans received from US and European banks carried variable interest rates to reduce the risk to the banks from unexpected inflation. When restrictive monetary policy in the US pushed up US interest rates, interest obligations by foreign countries also suddenly rose. Thus, international debt with variable interest rates potentially rise the likelihood of default.

Default can also occur if a country's ability to repay suddenly falls. This can occur if the country enters into a recession. Recessions imply falling GDP which reduces the pool of funds available for repayment. If the recession is induced by a reduction in exports, perhaps because of recessions in major trading partner countries, then the ability to finance foreign interest and principal repayments is reduced. Thus a recession in the midst of a large international debt position can risk potential default on international obligations.

But, what are the problems associated with a sudden increase in debt repayment if default on the debt does not occur? The problem, really, is that the country might suddenly have to begin running current account surpluses in order to maintain repayments of their international obligations. Remember that trade deficits mean that the country can spend more than its income. That's a good thing. Current account surpluses mean that the country must spend less than its income. That's the bad thing, especially in the face of an economic recession.

However, since this problem arises only when a net debtor country runs a current account surplus, we'll take up this case in the next section. Note well though that the problems associated with a trade deficit run by a net debtor country are generally not visible during the period in which the trade deficit is run. It is more likely that a large international debt will pose problems in the future if, or when, substantial repayment begins.

In summary, the problem of trade deficits run by a net debtor country is more worrisome,

  1. the larger is the net debt position
  2. the larger is the net debt (rather than equity) position
  3. the larger is the CA deficit (> 5% of GDP is large according to Summers)
  4. although large deficit with small net asset position is less worrisome
  5. or the larger is the KA surplus (especially net debt obligations)
  6. the more net debt is government obligations or government-backed
  7. the larger is the government deficit
  8. if a high % of debt is denominated in foreign currency and if the exchange rate has or will depreciate substantially
  9. if rising net debt precedes slower GDP growth
  10. if rising net debt correlates with falling investment
  11. if deficits correspond to "excessive" increase in (C + G) per capita
  12. especially if G is not capital investment
  13. if interest rate on external debt is variable
  14. if a large recession is imminent

The situation is benign or beneficial if the reverse occurs.

Case 2) Net Debtor Nation Running a Current Account Surplus

This case generally corresponds to a country in the process of repaying past debt. Alternatively foreigners may be divesting themselves of domestic equity assets. In either case, the trade surplus will reduce the country's net debtor position and will require that domestic spending is less than national income. This case is especially problematic if it arises because a currency depreciation has forced a sudden change in the country's required repayments on international debt. This is the outcome when a series of trade deficits proves to be unsustainable. What unsustainability means is that the deficits can no longer be continued. Once external financing is no longer available, the country would not have the option to rollover past obligations. In this case, in the absence of default, the country's net repayment on current debt would rise and push the capital account into deficit and hence the trade account into surplus.

When this turnaround occurs rapidly, the country suddenly changes from a state in which it spends more on consumption, investment and government than its income, to a state in which it spends less on these items than its income. Even if GDP stayed the same, the country would likely suffer severe reductions in its standard of living and reductions in its investment spending. The rapid reduction in domestic demands are generally sufficient to plunge the economy into a recession as well. This reduction in GDP further exacerbates the problem.

This problematic outcome is made worse, nationally, when the most of the debt repayment obligations are by the domestic government or if the external obligations are government-backed. A government that must suddenly make larger than expected repayments of debt must finance these efforts either by raising taxes or by reducing government benefits. The burden of the repayment, then, is borne by the general population. Exactly who suffers more and who less will depend on the nature of the budget adjustments, although it often seems that poorer segments of the population bear the brunt of the adjustment costs.

If the sudden increase in debt repayment were primarily by private firms then the burdens would fall on the associates of those firms rather than the general population. If this occurs on a small scale then we can view this as normal adjustments in a free market system: some firms always go bust forcing dislocations of labor and capital. The general population in this case would not bear the burden of adjustment unless they are affiliated with the affected firms.

However, even if the debt repayment burden is private and even if the government had not previously guaranteed that debt, the government may feel compelled to intervene with assistance if many private firms are negatively affected. This will perhaps be even more likely if the affected private debt is held by major national banks. Default by enough banks can threaten the integrity of the banking system. Government intervention to save the banks would mean that the general population would essentially bear the burdens of private mistakes.

This kind of rapid reversal is precisely what happened to Indonesia, Thailand, Malaysia and South Korea in the aftermath of the Asian currency crisis in 1997. Afterwards, these countries recorded substantial current account surpluses. These surpluses should not be viewed as a sign of strong vibrant economies, but, rather reflect countries that are in the midst of recessions, struggling to repay their past obligations, and who are currently suffering a reduction in average living standards as a consequence.

The most severe consequences of a current account surplus as described above arise when the change from trade deficit to surplus is abrupt. If, on the other hand, the transition is smooth and gradual, then the economy may not suffer noticeably at all. For example, consider a country that has financed a period of extra spending on infrastructure and private investment by running trade deficits and has become a net international debtor nation. However, once the investments begin to take off, fueling rapid economic growth, the country begins to repay more past debt than the new debt that it incurs each period. In this case the country could make a smooth transition from a trade deficit to a trade surplus. As long as GDP growth continued sufficiently fast, the nation might not even need to suffer reductions in its average living standards even though it is spending less than its income during the repayment period.

In summary the situation of a net debtor nation running current account surpluses is more worrisome,

  1. if surpluses follow default
  2. if GDP growth rate is low or negative
  3. if investment rate is low or falling
  4. if real C + G per capita is falling
  5. if surplus corresponds to rising net debt and larger equity sales

The situation is benign or beneficial if the reverse occurs.

Case 3) Net Creditor Nation Running a Current Account Surplus

A net creditor country with trade surpluses is channeling savings to the rest of the world either through lending or through the purchase of foreign productive assets. The situation is generally viewed as prudent but may have some unpleasant consequences. Recall that a country with a trade surplus is spending less on consumption, investment and government combined than their national income. The excess is being saved abroad. Net creditor status means that the country has more total savings abroad than foreigners have in their country.

The first problem may arise if the surplus corresponds to the substitution of foreign investment for domestic investment. In an era of relatively free capital mobility, countries may decide that the rate of return is higher and the risk is lower on foreign investments compared to domestic investments. If domestic investment falls as a result, future growth prospects for the country are reduced as well. This situation has been a problem in Russia and other transition economies.

The second problem arises even if domestic investment remains high. With domestic investment kept high, the cost of the large surpluses must be felt as a reduction in consumption and government spending. In this case a large trade surplus leads to a reduction in average living standards for the country. This is a point worth emphasizing. Countries that run trade surpluses suffer a reduction in living standards, not an increase, relative to the case of balanced trade.

Another potential problem with being an net creditor country is the risk associated with international lending and asset purchases. First of all, foreign direct investments may not pay off as hoped or expected. Portfolio investments in foreign stock markets can suddenly be reduced in value if the foreign stock market crashes. On international loans, foreign nations may default on all or part the loans outstanding, may defer payments, or may be forced to reschedule payments. This is a more likely event if the outstanding loans are to foreign countries with national external debts that may prove unsustainable. If the foreign country suffers a rapid currency depreciation, and if the foreign loans are denominated in domestic currency, then the foreign country may be forced to default. Defaults may also occur if the foreign debtor countries suffer severe recessions. The creditor nation in these cases is the one that must suffer the losses.

It was this situation that was especially serious for the US at the onset of the third world debt crisis in the early 1980s. At the time a number of large US banks had a considerable proportion of their asset portfolios as loans to third world countries. Had these countries defaulted en masse, it would have threatened the solvency of these banks and could have led to a serious banking crisis in the US economy.

Alternatively, suppose the surplus country has made external loans in the foreign countries' currency. If the foreign currency depreciates, even if only gradually, then the value of the foreign assets falls in terms of the domestic currency. The realized rates of return on these assets could then become negative, falling far short of returns on comparable domestic assets.

In summary, the situation of a net creditor nation running current account surpluses is worrisome,

  1. if net credit position is very large
  2. if the current account surplus is very large
  3. if GDP growth rate is low
  4. if investment rate is low or falling
  5. if C + G per capita is low or falling
  6. if the domestic currency has appreciated substantially

The situation is benign or beneficial if the reverse occurs.

Case 4) Net Creditor Nation Running a Current Account Deficit

In general, a deficit run by a country that is a net creditor is least likely to be problematic. In essence this describes a country that is drawing down previously accumulated savings. The deficit also implies that the country is spending more than its income. This situation is especially good if it allows the country to maintain living standards during a recession. This case would also be good if a country with a rapidly aging population is drawing down previous savings to maintain average living standards.

The current account deficit can cause problems if as in case 1, the deficit corresponds to falling investment and increases in consumption and government expenditures. If these changes occur while the economy continues to grow, then it may indicate potential problems for future economic growth. However, if the same changes occur while the economy is in a recession, then the effect would be to maintain average living standards by drawing down external savings. If this occurs only during the recession, then the long-term effect on growth would be mitigated.

This case can be a problem if the net creditor position is extremely large. A large amount of foreign savings can always potentially drop in value given currency fluctuations as described above in case 3. However, the current account deficit only serves to reduce this potential problem since it reduces the country's net creditor position.

In summary the situation of a net creditor nation running current account deficits is worrisome,

  1. the smaller is the net creditor status and the larger is the deficit (although this is generally less worrisome than if the country were a net debtor)
  2. if investment is falling, although a temporary drop in I is likely in a recession
  3. if C + G per capita is rising rapidly

The situation is benign or beneficial if the reverse occurs.

IV. Conclusion

This chapter has highlighted the criteria that should be used to evaluate whether trade imbalances are problematic, beneficial, or benign. The emphasis has been on the capital account imbalances that accompany every current account (trade) imbalance and on the country's international investment (asset) position. These accounts reveal the international lending and borrowing, and purchase and sale of productive assets that underlies every trade imbalance. They also provide a more complete description of exactly what is going on in a country when it runs a trade imbalance.

It is shown that evaluation should begin by noting not just whether the country has a trade deficit or surplus, but also, whether it is a net debtor nation or a net creditor nation. Four separate situations, or cases, are analyzed, each of which has different implications. A number of important general observations arise.

First, it simply is not the case that trade deficits are a problem and trade surpluses a virtue. There are many cases in which the opposite conclusion should be drawn. Second, many different factors should be considered in making an evaluation. It simply is not possible, knowing only whether a country has a trade imbalance and whether it has risen or fallen in the past few months or years, to know whether the change represents a problem or not.

Third, it is worth repeating that because trade deficits correspond to national spending levels in excess of production or income, they also represent situations in which a country can consume and invest more than it could with balanced trade. In a simple sense then trade deficits confer real advantages for countries. Trade surpluses, on the other hand, correspond to a situation in which national spending falls short of national production and income. In other words, consumption and investment must be less than would arise with balanced trade. Thus, trade surpluses have a negative effect on consumption possibilities for countries. Indeed, the real problem with countries that run persistent trade deficits is that in the future they might be forced to run large trade surpluses. Economic problems are not present while the deficits are being run, they arise when the surpluses come. This observation is completely contrary to what seems to be the common view about deficits and surpluses.

Finally, this analysis has purposely avoided discussion of a few other features of trade imbalances which are obtained by looking at the goods and services imbalances. In particular, I have not mentioned the effects of changes in imports or exports on aggregate demand and its possible effect on GDP, nor have I discussed the effects of changes in the trade imbalance on employment either within sectors or nationally. I have also ignored the problem of how perceptions about the effects of trade imbalances can lead to calls for trade protectionism and the subsequent problems that this might cause. Although these considerations have some validity, because they are overly emphasized in most discussions of trade imbalances, it seems appropriate to underemphasize them here in order to compensate.

The next section includes an application of these criteria to 13 separate countries. Each country review will examine the pattern of trade imbalances over the past 20 years (when data is available) as well as the evolution of its international asset position. By examining other macroeconomic variables, each report will attempt to identify whether the country's pattern of trade imbalance was good, bad or benign.


1. Here GDP is gross domestic product, C is domestic consumption expenditures, I is domestic investment expenditures, G is domestic government expenditures, EX is exports and IM is imports. Note that EX - IM represents the current account balance and should include income payments and unilateral transfers as well as goods and services trade.

2. We will use the term trade balance (deficit and surplus) to refer to the current account balance throughout the paper. The trade balance is sometimes used to describe only the balance on merchandise goods trade, however, the current account provides a more complete description of trade flows.


References

Griswold, Daniel T. (1998), "America's Maligned and Misunderstood Trade Deficit," Cato Institute: Trade Policy Ananlysis, No. 2, April 20, 1998.

Roubini, Nouriel and Paul Wachtel, 1997, "Current Account Sustainability in Transition Economies," Draft available at http://equity.stern.nyu.edu/~nroubini/asia/EastEurope.pdf.

Taylor, Timothy (1999), "Untangling the Trade Deficit," The Public Interest, 134, pp.82.


©1999 The Elliott School of International Affairs, The George Washington University, ALL RIGHTS RESERVED Last Updated on 10/9/99