U.S. Trade Balance and Exchange Rate Term Paper

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U.S. Trade Balance & Exchange Rate

US Trade Balance and Exchange Rate

Most economists agree that there is a definite relationship between trade balance and the exchange rate. It is a general rule of economics that a negative trade balance (or trade deficit) normally leads to a weaker currency, and a positive trade balance (or trade surplus) results in enhanced value of the currency, although there are exceptions to the rule as several other factors may prevent such weakness or strength. The issue of trade balance and its effect on exchange rate of the country's currency is currently in the limelight because of the burgeoning U.S. trade deficit and the declining value of the U.S. dollar against some of the major world currencies. In this paper, I shall discuss the relationship between trade balance and exchange rate with particular reference to the United States besides exploring the other implication of the U.S. consistently running a trade balance deficit and suggesting some solutions to the deficit dilemma.

What is Trade Balance?

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In economics, trade balance refers to the value of all the goods and services a country sells to other countries (its exports) minus the value of all the goods and services it buys from other countries (its imports). A positive balance of trade is called a trade surplus and a negative balance of trade is trade deficit. Neither condition is necessarily bad, but a large, persistent (and rising) trade deficit such as being experienced by the United States during the last several years could be a sign of economic problems. Even a positive trade balance, which at first sight seems desirable, may not always be so, as exemplified by Japan in the 1990s. The trade balance is reflected in the balance of payments account that has two heads: a) the current account, which monitors all trade activities -- the export and import, income from investments abroad, and money paid to foreign investors; and b) the capital account, which tracks the loans given to foreign countries and the loans received. (Ruby, 2003)

What is Exchange Rate?

Term Paper on U.S. Trade Balance and Exchange Rate Assignment

Exchange rate refers to how much one currency is worth in terms of another. For example, an exchange rate of 100 Japanese Yen to a U.S. dollar means that the worth of 100 Yens is one U.S. dollar. If a currency is strengthening, i.e., it is becoming more valuable, it is said to be appreciating. On the other hand, if a currency is weakening, i.e., it is losing its value, it is said to be depreciating. A depreciating or appreciating currency may not always exhibit the same behavior against all currencies. For example, the dollar over the last few years has lost in value against the Euro, the Canadian dollar and the Japanese Yen but appreciated relative to the Mexican Peso and stayed relatively flat against the Chinese Yuan. (Moffat, n.d.) Some countries have a floating exchange rate, i.e., the market conditions, demand and supply determine its value; in others, the governments determine the exchange rate according to their policy needs.

The Extent of Trade Balance Deficit in the U.S.

As mentioned in the introduction, the U.S. has been running a trade balance deficit during the last several years. This trend started in the 1980s and continues to grow to date. For example, the latest trade deficit figures show that the U.S. trade deficit skyrocketed to a new all time high in February 2005 when it shot up to $61 billion for the month alone. (Beck, 2005) Such an amount, when extrapolated over the year means a trade deficit of $717 billion per year. The U.S. trade deficit for last year was $617 billion and $549 billion for 2003. The figures represent an unmistakable and fast rising trend of the U.S. trade deficit, which is clearly alarming. (Ibid.)

The question that comes to mind is how has the U.S. been able to support such a large trade deficit for so long. The answer lies in the concepts of the "capital account and the "reserve currency." As we saw in the para on Trade Balance, the balance of payments account has a head called the capital account that monitors the loans given and the loans received. The United States has, thus been able to keep its "balance of payments" account balanced by attracting massive loans from other countries. Why other countries are willing to finance the U.S. trade deficit so far is due to the U.S. dollar's role as a reserve currency.

What is a Reserve Currency?

When people have confidence in the value of a currency, i.e., it is perceived to be relatively stable over the long-term and is supported by a large economy, open and deep financial markets, and low inflation, it assumes the status of the reserve currency. Such currency is held in significant quantities by other governments and institutions as part of their foreign exchange reserves. The U.S. dollar has held the status of the world's reserve currency after the Second World War. Hence countries that are running large trade surpluses such as China and Japan use their 'surplus' funds to purchase U.S. Treasury Notes, allowing the United States to export its paper (the dollar) to get real goods and services in return. Another factor that enable the U.S. To keep running such large trade deficits is that oil is priced in the reserve currency (the U.S. dollars) that compels many nations (and several institutions) to hold some of their reserves in U.S. dollars to hedge against the volatile price of oil. ("Balance of Trade," 2005) the status of the dollar as the sole reserve currency in the world has yielded significant economic benefits for America, by enabling it to pay for imports and borrow in domestic currency and at low interest costs.

Can the U.S. Dollar Retain its 'Reserve Currency' Status for Long?

The key question is, can the U.S. dollar retain its status of the resrve currency for long? History suggests that it may not. Before the advent of the dollar as the world's reserve currency, the British Pound had enjoyed such a status. Between the two World Wars and the post-World War II period saw the weakeing of the British economy. As a result, the British Pound was devalued by 30% in 1949, effectively ending its run as the world's reserve currency and the start of the dollar's reign. Dollar has been able to retain its status as the reserve currency since it was relatively stable, was backed up by the formidable economy of the U.S., low interest rates and the absence of an alternative currency. (Mann 1999, p. 56) Recent events including erosion in the value of the dollar, weaknesses in the U.S. economy, persistant high levels of trade deficit, and the availability of an alternate currency -- the euro, indicate that the dollar too may be approaching the end of its long run as the reserve currency.

Is the U.S. Trade Deficit Sustainable?

Some economists, including the U.S. treasury officials, contend that the U.S. trade deficit is nothing to be alarmed about as the country's economy and the U.S. dollar survived a similar slide in the late 1980s. This argument is hard to digest since the country's current-account deficit, currently running at close to 6% of GDP, is almost twice as big as at its peak in the late 1980s ("The Passing of the Buck?" 2004). Mooreover, while the U.S. was a net foreign creditor in the 1980s, at the end of 2004 its net foreign liabilities stood at $3.3 trillion dollars, or 28% of the GDP.

The optimists dismiss the alarm at the trade deficit by arguing that the large deficit is a sign of America's economic might and the direct result of a capital accounts surplus funded by investors queing up to invest in the U.S. And to lend it money. Such optimism, again seems misplaced because unlike the 1990s when large investments were being made in U.S. equity markets by private investors, the current account deficit is now being supported largely by the foreign central banks (especially Asian central banks) which are buying dollars to prevent their own currencies from appreciating and to support their own export-led growth despite the risk of future capital losses. According to Bank of International Settlements (BIS) estimates, central banks provided $441 billion of the $531 billion needed to finance the United States' 2003 current account deficit. (Roubini and Setser 2004, p. 4).

How long these central banks would be willing to continue holding dollars exclusively as their foreign exchange reserves and to continue financing the U.S. current account deficit is the trillion dollar question. Already, disturbing statements are beginning to emanate from some important players that the banks would like to diversify their foreign exchange holdings. Moreover, the scale of financing required from Asian central banks to sustain the exploding U.S. current account deficits in future would soon exceed the absorption capacity of Asian central banks. This is because current estimates indicate that central bank reserves would have… [END OF PREVIEW] . . . READ MORE

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