During one trade deficitthe US dollar has cushion or weakened, but in many other cases, the dollar strengthened. There are numerous driving variables exchange courses in addition to the balance of payments, including investment flows into a country, economic growthinterest rates and government policies. A trade deficit is usually a negative headwind for the US dollar, but the dollar has been able to appreciate due to other factors.

How a trade deficit works

A trade deficit means that the United States buys more goods and services from abroad (import) than is sold abroad (exporting). 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 those goods. Countries may also lack the skilled labor to manufacture their own goods and therefore be dependent on more developed nations. At other times, a trade deficit may be due, in part, to the fact that foreign goods are cheaper than domestically produced goods.

imports

If imports continue to outpace exports, the trade deficit may worsen, leading to more US dollar outflows. In other words, foreign imports, which are purchased by American consumers, are paid for by exchanging US dollars for the international company’s foreign currency. So if imports increase, there may be an increase in the aggregate amount of dollars leaving the country.

Exports

Conversely, if a foreign company buys US exports, it makes an exchange their local currency for dollars to facilitate purchase, leading to higher demand for dollars. However, if exports are down, it means there is less demand for US goods by foreigners. Lower demand for dollar-denominated goods may result in a weaker dollar exchange rate against other foreign currencies.

dollar

The flow of dollars out of the country and the lack of foreign demand for US exports may lead to a depreciation of the dollar. However, as the dollar weakens, US exports become cheaper for foreigners because they can get more US dollars for the same amount of their currency to buy US goods. Even if the price of exported goods has not changed, foreigners can buy American goods at a discount when the dollar is weaker.

Increased demand for US exports leads to more foreign currencies being exchanged for dollars, which increases the dollar’s exchange rate against the currencies involved. The (theoretical) result should be a trade deficit that is brought back to balance. However, in reality this is rarely understood, as the demand – or lack of demand – for a country’s goods is determined by factors other than the exchange rate.

Why isn’t the US dollar weakening?

The US has run persistent trade deficits since the mid-1970s, but this has not translated into significant dollar weakness as expected.

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

Reserve currency status of the dollar

The American dollar belongs to the world reserve currencythat is, it is used to facilitate transactions in commerce, by central banksand by corporations. Emerging market economiesfor example, they set the price of their government BONDS or dollar debt because developing countries’ currencies are usually not stable. Also a lot commodities they are priced in dollars, including gold and crude oil. All these dollar-denominated transactions provide a boost (or trough) to the dollar’s exchange rate against the foreign currencies involved.

Investment capital flows

Huge global demand for US Treasurywhich are owned by corporations, investors and central banks leads to capital flows coming into the US from other countries. Foreign investment firms convert their domestic currencies into US dollars to buy US government securities or other assets.

As a result, the dollar often strengthens when foreign investment flows into the US. All this global demand for dollars helps offset the dollar’s weakness from the trade deficit. That’s not to say the trade deficit can’t weaken the dollar because it can, but it’s difficult to pinpoint whether any weakness is caused solely by an increase in imports or a decrease in US exports. The dollar’s reserve currency status and capital flows in and out of the US also influence the dollar, making it difficult to determine which is the root cause of any dollar strength or weakness.

Major economies that issue their own currency, such as the UK, India and Canada, are in a similar space where they can run persistent trade deficits. Countries that do not have the faith of the investing community are more likely to see their currencies 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 have been no changes in capital flows into and out of the US, which would also impact the dollar.

For example, suppose a company sold a cell phone case to a European company, which agreed to pay the American manufacturer $10,000. At the time of completion of the transaction, the European company could exchange euro for dollars at a rate of $1.10, meaning it would cost them €9,090 to pay the $10,000 bill ($10,000 / $1.10).

However, before the payment is due, the US dollar weakens or depreciates against the euro and the exchange rate suddenly moves to $1.14. As a result, it costs the European company only €8,772 to pay the $10,000 bill ($10,000 / $1.14).

The European company paid the same bill of $10,000, but saved 318 euros due to the movement of the exchange rate between the time of purchase and the time the payment was made to the American company. In other words, a depreciating dollar (or a stronger, more expensive euro) makes US exported goods cheaper based on the movement of the exchange rate alone.

It is important to note that the weaker dollar may ultimately lead to increased demand for US goods or exports from foreign companies. If demand is strong 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 moderation of the trade deficit.