What happens to the US dollar during a trade deficit?

During trade deficits, the US dollar depreciated or weakened, but in many other cases the dollar strengthened. In addition to the balance of payments, there are many variables that influence exchange rates, including investment flows into a country, economic growth, interest rates and government policies. Trade deficits are usually a headwind for the US dollar, but the dollar was able to strengthen thanks to other factors.

How does a trade deficit work?

A trade deficit means that the United States buys more goods and services abroad (imports) than it sells abroad (exports). A trade deficit can occur when a country does not have the resources to produce the products it needs.

Countries may lack natural resources such as oil or natural gas and must import these goods. Countries may also lack skilled labor to produce their own goods and, as a result, become dependent on more developed countries. In other cases, a trade deficit may be due in part to foreign goods being cheaper than domestically produced goods.

Import

If imports continue to exceed exports, the trade deficit could worsen, leading to an even greater outflow of US dollars. In other words, foreign imports purchased by American consumers are paid for by exchanging U.S. dollars for the international company’s foreign currency. Thus, if imports increase, there may be an increase in the total number of dollars leaving the country.

Export

Conversely, if a foreign company buys US export goods, they exchange their local currency for dollars to make purchasing easier, which increases the demand for dollars. However, if exports fall, it means that foreign demand for American goods is declining. A decrease in demand for dollar-denominated goods may cause the dollar’s exchange rate to depreciate against other foreign currencies.

Dollar

The outflow of dollars from the country and the lack of external demand for American exports could lead to a fall in the dollar. However, as the dollar weakens, U.S. exports become cheaper for foreigners because they can get more U.S. dollars for the same amount of their currency to buy American goods. Even though the price of exported goods has not changed, foreigners can essentially buy American goods at a discount when the dollar weakens.

Increased demand for U.S. exports results in more foreign currency being exchanged for dollars, which increases the dollar’s exchange rate against participating currencies. The result (in theory) should be a balance in the trade deficit. In reality, however, this rarely works out so smoothly, since the demand—or lack thereof—for a country’s goods is driven by factors other than the exchange rate.

Why is the US dollar not weakening?

The US has run persistent trade deficits since the mid-1970s, but this has not led to significant dollar weakness as might be expected.

Below are some reasons why the dollar has maintained its strength over the years despite trade deficits.

Status of the dollar as a reserve currency

The US dollar is the world’s reserve currency, meaning it is used to facilitate trading transactions by central banks and corporations. For example, emerging market countries typically price their government bonds or debt in dollars because emerging market currencies are typically unstable. Additionally, many commodities are priced in dollars, including gold and crude oil. All of these transactions, denominated in dollars, provide an increase (or floor) in the exchange rate of the dollar against the foreign currencies involved.

Investment capital flows

Huge global demand for US Treasuries, held by corporations, investors and central banks, is leading to an influx of capital flowing into the US from other countries. Foreign investment companies convert their domestic currencies into U.S. dollars to purchase U.S. Treasury securities or other assets.

As a result, the dollar often strengthens when foreign investment comes into the United States. All this global demand for dollars helps offset the dollar’s weakness due to the trade deficit. This is not to say that trade deficits cannot weaken the dollar, because they can, but it is difficult to pinpoint whether any weakness is due solely to increased imports or decreased US exports. The dollar’s status as a reserve currency and capital flows into and out of the United States also influence the dollar, making it difficult to determine the underlying cause of the dollar’s strength or weakness.

Major economies that issue their own currencies, such as the UK, India and Canada, are in a similar space where they can run persistent trade deficits. Countries that are not trusted by the investment community are more likely to see their currency depreciate due to trade deficits.

Example of the dollar and the US trade deficit

Below is an example of how the dollar exchange rate can affect foreign trade. For illustrative purposes, we will assume that there are no changes in capital flows in and out of the US that would also affect the dollar.

For example, suppose a company sold cell phone frames to a European company, which agreed to pay the American manufacturer $10,000. At the time the transaction was completed, the European company could exchange euros for dollars at a rate of $1.10, meaning paying a $10,000 invoice would cost them €9,090 ($10,000/$1.10).

However, before the payment is due, the US dollar weakens or depreciates against the euro and the exchange rate suddenly rises to $1.14. As a result, paying a $10,000 invoice would cost the European company just €8,772 ($10,000/$1.14).

The European company paid the same invoice for US$10,000, but saved €318 due to changes in the exchange rate between the time of purchase and the time of payment to the US company. In other words, a depreciating dollar (or a stronger, more expensive euro) makes U.S. exports cheaper solely through changes in the exchange rate.

It’s important to note that a weaker dollar could ultimately lead to increased demand for American goods or exports from foreign companies. If demand is high enough, the dollar may eventually strengthen as there is increased demand for dollar-denominated exports. As a result, the exchange rate mechanism may lead to some easing of the trade deficit.