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Trade balance and exchange rate: what you need to know

Trade balance and exchange rate: what you need to know

Perhaps every trader while reading financial news comes across some incomprehensible concepts or just cannot trace the correlations between economic events and their reflection in statistics. We have decided to give you a hand in the vortex of this information and fill you in on any of the characteristics of forex market and exchange rate determinants.

Filling the gaps in our knowledge of the trade deficit and exchange rates correlation

To take a stab at helping you to understand the pressure that trade deficits might exert on the exchange rates, let me challenge you with some definitions.

Let’s look at something called the balance of payments. It is a record of all economic transactions between the residents of a certain country and the rest of the world for a given period of time. It consists of sub-accounts – the current account and the financial account. The current account records the sale and purchase of goods and services as well as unilateral transfers, whereas the capital (or financial) account records transactions of purchase and sale of foreign assets and liabilities during a particular year.

So when the US buys TVs from China, that should be recorded in the US current account. Thus, when Americans spend a whaling sum of money on Chinese goods, the people of China have only two things to do with that money in order to keep their balance of payments. They can buy US goods in return, or they can buy US financial assets (like stocks and bonds). And the later transactions will be already recorded in the other side of the account – the financial one. If consumers, governments or business of a certain country are searching to buy more staff than their country is producing domestically, they have to import it. So there is a trade deficit that has to be mitigated by selling financial assets to pay for the imports. If a country doesn’t take measures to eliminate this trade deficit, it may reduce its national indicators (GDP, in particular).


Takeaways: Trade surplus creates demand for the country’s currency and makes its exchange rate go up.


Impact on exchange rates

Once we shed light on some essential definitions, let us procced to the very essence of this article – the link between trade deficits and exchange rates. When a country exports more than it imports (in other words, when the difference between exports and imports is positive), the country is having a trade surplus; there is a high demand for its goods and thus for its currency. Law of demand states that when demand is high, prices rise and thus the currency appreciates in value.

Alternatively, when the opposite is true, when a country imports more than it exports, there is relatively less demand for its currency, so prices reduce. In this case, the country is experiencing a trade deficit, its currency automatically depreciates, and the country’s GDP is shrinking.

 

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