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What is a Trade Deficit?
International trade is the life force of the global economy, and its two fundamental principles are:
- Import what you need
- Export what you have in abundance
For example: if you are a small island nation, your economy may require you to import agricultural goods and export marine ones.
Now the foundation of all trade is trust. All stakeholders need to understand each other's economic conditions to establish trust on an international scale. This trust is provided by the balance of payments, a tool used to keep track of international transactions. The difference between the import and export values provides us with a 'trade deficit'.
Trade Deficit Calculation
The formula is simple:
Trade Deficit = Value of Import - Value of Export
However, trade deficits are mostly expressed in the context of the country's Gross Domestic Product to give the reader an understanding of the economy's health. The formula for that is:
Trade Deficit as percentage of the GDP = [(Value of Import - Value of Export) / GDP] * 100
For example: If your island nation has imported ₹1,00,000 worth of goods this year while exporting ₹80,000 and its annual GDP is ₹2,00,000,
The trade deficit is:
Import - Export
₹1,00,000 - ₹80,000
And the trade deficit as a percentage of the GDP is:
[(Import - Export) / GDP] * 100
[(₹1,00,000 - ₹80,000) / ₹2,00,000] * 100
[(20,000) / 2,00,000] * 100
[(1) / 10] * 100
0.1 * 100
So, the trade deficit for your island nation is ₹20,000, which translates to about 10%
of your GDP. That's quite a high number! What could it mean for your economy?
What Causes a Trade Deficit?
As you may have noticed above, the primary driver of a trade deficit is the 'value' of goods. This value can be affected by a number of factors:
- Economic growth: A trade deficit could actually indicate economic growth for your island nation. In a growing economy, consumers are more likely to have wealth that allows them to purchase and import high-value goods, thereby placing downward pressure on the trade deficit.
- Exchange rate flux: Perhaps this year, the currency of your island nation has not fared well compared to other countries. If your purchasing power has declined, trade is more costly to you. The value of your imports has increased while your exports have decreased. On the other hand, say the situation is reversed because you have a strong economy. If your currency fares better than others and strengthens your position in trade, consumers will import more goods to take advantage of the same.
- Limits of production: No weak or strong economy can produce everything it needs domestically. As with your island nation, the rules of geography have decided the fate of your agricultural sector. Importing potatoes may be wiser and cheaper than growing them on such limited land. Conversely, your energy sector may have learned how to harness the power of the sea effectively. Your trade deficit can vary depending on whether the global market values potatoes over cheap electricity this year or vice versa.
In this way, we have understood how a trade deficit arises.
But what are the effects of a trade deficit?
What are the advantages and disadvantages of a trade deficit?
Advantages of a Trade Deficit
Having a trade deficit can have certain advantages in the short term:
The increasing value of imports can signify a thriving economy where consumers are importing products at low prices.
Increased Local Spending
If the economy is not thriving, and the value of importing products has risen, consumers will generally turn to buying domestic goods, spelling respite for local manufacturers.
Increased Foreign Investment
Foreign investors are on the hunt for a good deal like everyone else. If your economy is struggling now but promises growth in the future, it will attract foreign investment.
Disadvantages of a Trade Deficit
Just like debt, the problem of a deficit grows more serious over time:
Let's lead with the last advantage. If your island nation has relied on foreign investment over a long period, the ownership of businesses, property, raw materials and other assets has transferred outside your country. This can leave your economy vulnerable to significant shifts in the global economy.
The lower the value of your exports over a long time, the weaker your position in the global economy. The weaker your position in the global economy, the lower the value of your currency. This can be somewhat addressed in the short term by having a fixed exchange rate. However, over time, a fixed exchange rate negatively impacts wages and overall employment.
Increased budget deficits
A few economists have also observed that a trade deficit is correlated with a budget deficit. The working assumption is that if your nation is already facing a sizable trade deficit, your government would be trying to limit internal spending on education, infrastructure and industry too.
India's Current Trade Deficit: The Short & Long Term View
A recent poll of economists conducted by Reuters found that India's current account deficit rose to its highest in nearly a decade in the July-September quarter, driven by high commodity prices, increasing internal demand for imported products since the COVID-19 pandemic, and a weak currency. Furthermore, exports shrank to a 20-month low in October 2022 because of a weakening global economy.
The economists in the Reuters poll converged on a median forecast of the trade deficit at 4.3% of the Gross Domestic Product, the highest in nearly a decade.
Over the next year, the World Trade Organization projects global trade to grow by just 1% in 2023, as compared to 3.5% in 2022.
Business Insider recently quoted the PHD Chamber of Commerce and Industry as saying that India's merchandise exports to G20 nations could be scaled up to a value of ₹413 lakh crores, significantly reducing the trade deficit.
Of India's recent 13 free trade agreements (FTAs), only three are with the G20 countries (Australia, Japan and the Republic of Korea). Among the total list of G20 countries, India currently holds a trade surplus with eight countries. The trade body, however, predicts more FTAs in the future, including countries such as the US, Canada, the UK and the European Union.