Question

Explain why and how net exports and net capital flow are related to each other. Does trade deficit necessarily create trouble for a county’s economic growth? Discuss.

Answer 1

1) Net exports of a country refers to the net of a country’s exports over its imports where exports are the value of goods & services sold by a country to the rest of world and import implies the value of goods & services bought by a country from the rest of world. It is measured by difference between exports and imports, i.e. Net Exports of nation A= Exports of nation A – Imports of nation A

Net capital outflow of a country refers to the difference between the capital outflow from the country and capital inflow in the country wherein capital outflow happens due to purchase of foreign assets by domestic residents and capital inflow occurs during purchase of domestic assets by foreign entity. Thus, Net capital outflow of nation A = Capital outflow from nation A – Capital inflow in nation A

Net exports of a nation is always equal to its Net capital outflow at any point of time.

This happens because if net exports of a country is positive then it implies the value of its exports is more than value of its imports. Now, when a country exports to any foreign country then it earns revenue in foreign currency whereas when its imports from a foreign country then is pays cost in foreign currency. Hence, when net exports of a country is positive then it implies that the country is earning more foreign currency then it is losing. Now since foreign currency is also a type of foreign asset so this implies that the amount by which a country’s exports is more than its imports- it equal to the amount by which a country purchases and sells a foreign asset (in this case foreign currency).

On the contrary, when net exports of a country is negative, i.e. value of its imports is more than the value of its exports, then it must either borrow or buy a foreign currency to pay of its excess imports over exports. Now, a country will borrow or buy a foreign currency when it undertakes loan in foreign currency from foreign entities or if foreign entities invest in domestic country or if domestic country sells its assets to a foreign entity in exchange for foreign currency. In either case, the amount by which the value of exports is less than import becomes the net capital inflow for a country.

2) Positive net exports is also called trade surplus and negative net exports is also called trade deficit. As discussed above, trade deficit is also equal to the net foreign capital inflow, i.e. net foreign investment or borrowing.

Economic growth refers to the growth rate of country’s output and depends upon multiple aggregate demand and supply-side factors.

Now, relation between country’s trade deficit and economic growth also depends on multiple conditions chiefly being the nature of trade deficit and capital inflow and also whether we are considering short-run or long-run time-period.

On the one hand, higher trade deficit implies lower relative demand for domestic goods & services in relation to foreign goods & services, and thus lowers demand for country’s output and hence lower’s its supply and growth rate in the short run.

Moreover, if the higher trade deficit involves products which are used for final consumption, then it may not be useful for the country’s growth either in short or long-run but if the share of capital goods is more prominent in the net imports, then the country may benefit in long-run via higher productive capacity.

However, on the other hand, higher trade deficit also implies higher foreign investment and debt which if borrowed in favourable terms and used productively in high growth sectors or public infrastructure can lead to higher investment and hence higher economic growth of country in future in long run.

But a country may be involved in foreign debt trap and lower economic growth in long run if the terms of borrowing are not favourable or if the funds are not used efficiently in productive areas.

Hence, trade deficit can be risky and troublesome for country’s economic growth as well as beneficial and useful trigger for higher economic growth. In the short run, higher trade deficit always reduced economic growth but in the medium and long run it can make economic growth lower or higher depending upon multiple conditions and factors.