What are trade deficits? Why are they important? Are they really bad? Why should I pay attention to them? Will Cyclopip finally have a date this Valentine's Day?
If you've ever asked yourself any of the first four questions, don't worry, I've got your back! Read up on everything you need to know about trade deficits. Who knows, your newfound knowledge may just impress a pretty little lady and keep you from being like Cyclopip who hasn't had a Valentine for the past ten years.
Let's get started.
When talking about the current account, we are basically talking about the flow of money into and out of a certain country. The current account is the sum of the trade balance (or the net difference between imported and exported goods and services), transfer payments, and net factor income.
For example, you can bet your future Lamborghini that the U.S. would print a deficit whenever the Census Bureau releases the country's trade figures. It always does. This means that more money flowed out of the U.S. than went in. On the other hand, in an export-oriented economy like Japan, the current account balance is usually positive.
Normally, the market considers surpluses as good while deficits are seen as bad indications for the economy. In reality, however, current account deficits (to be more concrete) aren't necessarily bad. It all depends on the situation.
Let me illustrate through a hypothetical situation.
Mr. Jones is a very wealthy businessman who owns the number one automobile production company in the U.S. For 40 years, he has been operating all of his business in the U.S. However, due to rising wages, he was finding it difficult to remain competitive and keep costs low.
After much deliberation, Mr. Jones decided to move part of his production to China where labor is cheaper. A large amount of money would then flow into China as capital, machinery, building materials, office furniture - heck, you name it - are moved. This would be considered as imports for China and would appear as huge deficit.
Is that necessarily bad? Of course not! China didn't spend beyond its means at all, but rather, there was just a sudden influx of capital. It's actually a good thing since it will lead to more jobs, possibly higher wages, and better standards of living.
Here's another example. An emerging country may need to borrow cash and acquire certain services abroad to keep its consumption at stable levels while implementing projects. Consequently, this could translate to a trade deficit but eventually, when it gets the return on investment as it grows richer it would be able to pay off its debt.
Now, what if a country is running a persistent current account deficit due to uncompetitive and/or low-quality exported products? Obviously, you've got a problem. In time, the export sector could contract, and result in reduced economic activity.
Long-term traders, especially those who hold positions for months at a time, ought to watch out current account balance reports. But instead of just glancing at the headline figures, take time to dig deeper and determine why a country incurred an account deficit (or surplus).
One might think that an economy is doing poorly because it printed a negative balance which is not always the case. Perhaps the reason behind the figure is because it is just heavily-invested in infrastructure.
So there you go! Hopefully, this brief lesson on deficits helped you grasp the importance of knowing the underlying factors behind account balance reports which may affect the long-term price action of currencies.
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