Currently, one of the most important developments we see is depreciation of the dollar. It has been a major source of concern for Indian exporters and India’s Balance of Payments.
The positive aspect of dollar depreciation is that it would lead to reduction of US trade deficit which is about USD 600 billion as of now. In one of the papers by Martin Feldstein which I covered here, Feldstein had argued that for trade deficit to reduce, either USD should depreciate or savings should increase. He had also said that it would be better if USD depreciates first.
Now, we see dollar depreciating (as there is no sign of savings improving, we see Feldstein’s wishlist coming true) so ideally theory would say US exports would increase and imports decrease and trade deficit will reduce. Right? Not really.
In this analysis by New York Fed Economists (Linda Goldberg and Eleanor Wiske Dillon), they say the reduction in deficit is going to be very little. They give 3 reasons:
1. Extensive use of USD in invoicing imports: Despite adoption of Euro, USD dominates foreign trade invoicing. Euro dominates European countries trade invoices but Asian nations, Australia etc still use USD extensively. They have a table (Table2), which summarises the currency invoicing pattern. The authors explain:
When foreign producers invoice their exports to the United States in dollars, the price of these goods remains fixed in the buyer’s currency if the dollar depreciates against other currencies. The exchange rate movements affect only the foreign producers’ profits and will not increase the dollar price paid by U.S. importers. After a time, of course, foreign producers may choose to adjust their prices in response to the exchange rate change. But evidence suggests that exporters set prices in dollars well in advance of the delivery of their goods and change those prices only periodically.
2. Market share concerns of foreign exporters: The authors say US is a big and a very competitive market for exporters and in case of dollar depreciation, they would reduce their margins rather than pass on the costs to the consumers. Moreover, Imports are a smaller component in the consumption basket (compared to other countries) and in case of any price increases, the US consumer would shift to domestic producers.
3. Sizable distribution costs: The above two are factors when goods comes to the border. The high distribution costs in US (The authors cite a paper which shows US has higher than average distribution costs across most consumption goods) further insulate the impact of depreciating dollar.
So, USD depreciation would lead to little impact on imports but the effect on exports would be higher. This is also reflected by looking at trade elasticities i.e. impact on US exports or imports given dollar’s value changes by 1%. The authors cite a study which says:
Using data from the 1960s to the mid-1990s, they estimate that demand for U.S. exports reacts more than proportionally to changes in export prices, rising 1.5 percent for every 1 percent drop in export prices. U.S. demand for imports, however, reacts less than proportionally to price changes, rising only 0.3 percent for a 1 percent drop in import prices. While this asymmetry is present in the trade elasticities of most other G7 countries, it is most pronounced for the United States.
They combine all this and project asking if USD depreciates by 10% what would happen?
|Change in home currency price
of bilateral imports
|Change in bilateral demand
The first row shows the effects on price and the second row shows the effects on demand. So, a 10 percent dollar depreciation has following effects:
- lowers the prices of U.S. exports by 7%
- raises the prices of US imports by at most a 4%
- foreign demand for U.S. exports would rise 10 %
- U.S. demand for imports from abroad would decrease only 1% in the six quarters after the depreciation. (Note that the decline in import demand may be overestimated because we omit the distribution services that further cushion the effects of the depreciation on the prices ultimately paid by consumers.)
In nutshell, US exporters gain and as prices of imports in US hardly increases, the imported items would continue to be purchased and hence the impact on deficit would not be as much as expected. As prices of US imports don’t rise, the foreign exporters bear much of the fallouts of depreciation.
They summarise the paper as:
Even a marked rise in exports, however, is by itself unlikely to erase the U.S. trade deficit. In 2006, that deficit stood at $759 billion. If imports and terms of trade remained constant, exports would have to grow 52 percent to single-handedly close this gap. Either import demand will have to become more responsive to exchange rate movements or adjustment will have to take place through other developments that would affect demand. These other developments might include increases in U.S. public or private saving (with related declines in U.S. consumption of all goods) or a rise in global demand driven by economic growth abroad or increased market access for U.S. exporters.
Revisiting Feldstein paper, it seems only way to get out of this deficit is increase savings.
I am sure there would be papers ahead countering/ supporting the above view as it looks quite a contradictory statement to make and against the popular held (and shared) beliefs.