Having imbalance in international trade – either large trade deficit or too much trade surplus – is usually not a good idea for a country. This is a serious business problem too as it deals with varying foreign exchange, therefore impacts international trade – all exporters and importers.
In general, it is better for a country to have healthy Balance of Payment, or to have trade surplus which is when Trade Balance is positive (exports > imports). It is because more money enters into the country from overseas than leaves the country. So, people and businesses are getting wealthier. Otherwise, when the country’s economy has a large persistent trade deficit on its Balance of Trade (exports < imports), then that serious economic problem emerges.
The problem is that more foreign currency will be flowing out of the country than coming in. This will cause a gradual decline in the country’s reserves of foreign currency, or may cause a dangerous shortage of foreign currency. The numbers will be showed in Official Settlements Account in Balance of Payment. The country may even run out of foreign currencies at all. And, the government of the country, in order to pay for all those imports, will have to borrow foreign currencies abroad from other countries’ central banks at a very expensive rates of interest.
Correcting imbalance in international trade
How to solve imbalance in international trade then? The government can take corrective actions as soon as possible. There are two ways to do so.
1. Alter exchange rates. The exchange rate is the price of one currency in terms of another. It measures the value of the domestic currency in terms of foreign currencies. It is determined by the laws of demand and supply on the Forex market.
Forex (FX) is the marketplace for currencies where national currencies are traded. It is the largest and the most liquid market in the world, with trillions of dollars in daily trading activity. Investopedia.com wrote a pretty neat article about the Forex (FX) market.
2. Adjust international trade barriers. Trade barriers are restrictions that might limit or prevent trading between countries. The examples include import tariffs, import quotas, embargoes, etc. When free trade agreements exist, countries are trading without any trade barriers.
A. To correct trade surplus (Exports > Imports)
1. Currency Appreciation.
This means an increase in value of a home currency as measured by its exchange rate. A higher exchange rate means that prices of products imported from abroad into a country will be relatively lower. Cost of buying overseas will decrease meaning that importers will need less home currency to buy the same number of overseas products. It is good news for importers of raw materials.
On another hand, the prices of products exported overseas will increase for foreign buyers. Foreign buyers will need more overseas currency to buy the same number of products. So, it is bad news for companies selling products abroad.
(!!!) Currency appreciation will increase imports and decrease exports.
2. Eliminate trade barriers.
Encourage free trade between countries by eliminating protectionist measures in the form of trade barriers on imported products. The government supports free trade with other countries by lowering or cancelling import tariffs, import quotas and embargoes to increase imports, hence encourage people to buy products from other countries.
(!!!) More free trade will increase imports.
B. To correct trade deficit (Exports < Imports)
1. Currency Depreciation.
This means a decrease in value of a home currency as measured by its exchange rate. A lower exchange rate means that prices of products exported abroad will now be cheaper for overseas buyers. A lower exchange rate means that prices of products imported from abroad into a country will be relatively higher. Cost of buying overseas will increase meaning that importers will need more home currency to buy the same number of overseas products. It is bad news for importers of raw materials.
On another hand, the prices of products exported overseas will decrease for foreign buyers. Foreign buyers will need less overseas currency to buy the same number of products. So, it is good news for companies selling products abroad.
(!!!) Currency depreciation will decrease imports and increase exports.
2. Set trade barriers.
Discourage free trade between countries by imposing international trade barriers in the form of restrictions on imported products, such as tariffs and quotas to artificially lower imports against exports. The government does not support free trade with other countries by introducing import tariffs, import quotas and embargoes to decrease imports, hence discourage people from buying products from other countries.
The government can also try to strengthen local producers against foreign competitors through subsidies – free financial support for local firms to reduce the cost of home producers increasing their price competitiveness globally.
(!!!) Less free trade will decrease imports.
Why altering exchange rates is not a good idea?
- For businesses, the exchange rate appreciation or depreciation make importing and exporting much riskier.
- If business managers are not be able to accurately forecast export sales or costs of imported raw materials due to exchange rate volatility, it makes sales forecasting useless.
- Large unpredictable and frequent fluctuations in exchange rates can create threats as business planning becomes very complex.
- Businesses may postpone international trade deals waiting for months for more favorable movements in the exchange rate.
- If domestic currency depreciates, the country’s local currency will now buy less goods abroad, so local producers using imported raw materials will pay more for importing from overseas.
- It can also create unwillingness of foreign investors to put money into the economy resulting in less Foreign Direct Investments (FDI).
Why adjusting international trade barriers is not a good idea?
- It might have only short-term benefits, but serious consequences in the long-term as a result such as worsened political relationships with other countries.
- Any trade restrictions will pose a barrier to trade, e.g. home businesses trying to establish themselves in overseas markets will have it very difficult.
- Foreign multinational businesses may invest much less in our home country due to exchange rate risks.
- This policy could lead to retaliation by other countries that will then reduce their exports.
- Also, import controls are serious for domestic firms that heavily depend on imported supplies of raw materials.
In summary, to correct imbalance in international trade, the government can attempt to alter exchange rate, or adjust international trade barriers. However, these actions will not be without long-term repercussions.
