In the United States, most producers focus on meeting the demands of the domestic market. Some, however, produce goods and services for export to foreign markets. Other businesses import those goods and services for which there is a demand or the United States does not produce. Half of the United States’ trade occurs with Canada, Mexico, China, Japan, Germany, and the United Kingdom.
Net exports, or the balance of trade, is equal to the value of all exports minus the value of all imports. Net exports in the United States are negative because the value of imports exceeds the value of exports. This is referred to as a balance of trade deficit.
Other countries like China, Germany, and Japan have balance of trade surpluses because the value of their exports exceeds that of their imports. Surprisingly, even though the United States has a balance of trade deficit, it is still the world’s largest exporter with 12% of the global share, compared to China with only 6.4%.
The balance of trade can be further broken down into the balance of trade in goods and the balance of trade in services. For the United States, the balance of trade in goods is what contributes to the trade deficit. Americans have a preference for foreign consumer goods and resources. On the other hand, the United States tends to be a net exporter of services. America’s transportation services and logistical know-how, as well as engineering, legal, and other technical services, are exported to the rest of the world.
The Commerce Department’s Bureau of Economic Analysis (BEA) is the government agency responsible for measuring the balance of trade. According to the BEA, in 2008 the trade deficit measured approximately $696 billion. This total trade deficit was composed of an $840 billion trade in goods deficit combined with a $144 billion trade in services surplus.
Whenever land, labor, capital, and entrepreneurship are employed, they receive payments of rent, wages, interest, and profits. It doesn’t matter whether the factors are employed domestically or abroad. When factors of production are employed abroad or the owners of those factors reside abroad, then the factor payments require foreign exchange. Regardless of whether it is an inflow of foreign factor income or an outflow of foreign factor payments, foreign exchange is required.
Other actions besides trade require foreign exchange. Transfer payments, called remittances, and foreign aid create outflows of currency from rich countries to poor countries in foreign exchange markets. Remittances differ from foreign factor income in that they are unearned by the recipients. Foreign aid in the form of cash payments also creates a need for foreign exchange. The United States’ aid payments to Pakistan, Israel, and Egypt are examples.
Unlike net exports, net foreign factor income, and net transfers, which involve one-time exchanges, net foreign investment creates recurring payments and income. When citizens of one country purchase the real or financial assets of another country, it is classified as net foreign investment. Net foreign investment also includes portfolio investment. Portfolio investment occurs when foreigners purchase the financial assets of another country. During the recent financial crisis, the dollar appreciated quickly as foreign investors sought the safety of U.S. Treasury bills, notes, and bonds. Purchasing shares of stock in foreign companies is another form of portfolio investment. Because developing countries often have higher rates of economic growth and higher rates of interest, financial investors might purchase bonds and stocks in these countries.
Which is better, a weak dollar or a strong dollar? It depends. Are you importing or exporting? Importers benefit from a strong dollar because it makes foreign goods relatively cheap. Exporters benefit from a weak dollar because it makes U.S. goods relatively cheap. So if you are going on a foreign vacation, hope for a strong dollar while you are there, and then hope it weakens on the flight back so that you profit on the exchange when you return.
Foreign investment is an important source of savings for the host country. These savings can be used to invest in physical capital and expand a country’s economy. This brings up an important point. The balance on the current account is completely offset by the balance on the financial account.
Foreign investment is not without its downside. Just as easily as savings can flow into a country through portfolio investment, the savings can flow out. A sudden outflow of savings may precipitate a currency crisis, inflation, and high interest rates for the affected country. This phenomenon has occurred before. The 2001 Argentine financial crisis is a notable example. Argentina defaulted on its foreign debt, and soon savings flowed out, which led to financial troubles and political turmoil as well.
Countries that fear capital outflows often enact capital controls. Capital controls limit the ability of savings to flow out of a country. During the Asian financial crisis of the late 1990s, India fared rather well as capital controls limited the outflow of savings from the country. The downside of capital controls is that they provide a reason for foreign investors to avoid placing their savings in a country. The mere mention of capital controls is sometimes all it takes for capital outflow to occur.