What Happens to the U.S. Dollar During a Trade Deficit?

The U.S. dollar typically depreciates or weakens during a trade deficit but it's strengthened in some cases. Numerous variables drive exchange rates in addition to the balance of payments. They include investment flows into a country, economic growth, interest rates, and government policies.

A trade deficit is typically a negative headwind for the U.S. dollar but the dollar has managed to appreciate due to other factors.

How a Trade Deficit Works

A trade deficit occurs when the United States is importing and buying more goods and services from abroad than it is selling abroad or exporting. A trade deficit can occur when a country doesn't have the resources to produce the products it needs.

Countries might lack natural resources such as oil or natural gas and they must therefore import those goods. They might also lack a skilled workforce to manufacture their own goods. They're dependent on more developed nations as a result. A trade deficit can also be partly due to foreign goods being less expensive than domestically-produced goods.

Imports

The trade deficit can worsen if imports continue to exceed exports, leading to more outflows of U.S. dollars. Foreign imports purchased by U.S. consumers are paid for by exchanging U.S. dollars for the foreign currency of the international company. There can be an increase in the aggregate amount of dollars leaving the country if imports are rising.

Exports

Foreign companies exchange their local currency for dollars to facilitate their purchases when they buy U.S. exports. This leads to more demand for dollars but it means there's less demand by foreigners for U.S. goods if exports are falling. The lower demand for dollar-denominated goods can lead to a weaker dollar exchange rate versus other foreign currencies.

The Dollar

The flow of dollars out of the country and the lack of foreign demand for U.S. exports can lead to a depreciation in the dollar. U.S. exports become cheaper to foreigners as the dollar weakens, however. They can get more U.S. dollars for the same amount of their currency to buy American goods. Foreigners essentially can buy U.S. goods at a discount when the dollar is weaker even though the price of the exported goods hasn't changed.

The increased demand for U.S. exports leads to more foreign currencies being exchanged for dollars and this increases the dollar exchange rate relative to the currencies involved. The result should theoretically be a trade deficit that's brought back into balance but it seldom works out that neatly. The demand or lack of demand for a country's goods is driven by factors other than the exchange rate.

Why Doesn't the U.S. Dollar Weaken?

The U.S. has run persistent trade deficits since the mid-1970s but this hasn't translated into significant dollar weakness as would be expected.

The dollar has maintained its strength over the years despite trade deficits for a few reasons.

The Dollar's Reserve Currency Status

The U.S. dollar is the world's reserve currency. It's used to facilitate transactions in trade by central banks and corporations.

Emerging market economies typically price their government bonds or debt in dollars because developing countries' currencies usually aren't stable. Many commodities are also priced in dollars including gold and crude oil. All these dollar-denominated transactions provide a boost or a floor to the dollar exchange rate versus the foreign currencies involved.

Investment Capital Flows

The huge global demand for U.S. Treasuries that are held by corporations, investors, and central banks leads to capital flows coming into the U.S. from other countries. Foreign investment firms convert their home currencies for U.S. dollars to purchase Treasury securities or other U.S.-based assets.

The dollar often strengthens as a result when foreign investment enters the U.S. All this global demand for dollars helps to offset dollar weakness due to the trade deficit. That's not to say that the trade deficit can't weaken the dollar but it's difficult to pinpoint whether any weakness is solely caused by an increase in imports or a decline in U.S. exports.

Major economies that issue their own currencies such as the United Kingdom, India, and Canada are in a similar space. They can run persistent trade deficits. Countries that don't have the faith of the investing community are more prone to seeing their currencies depreciate due to trade deficits.

Example of the Dollar and the U.S. Trade Deficit

Let's say a company sold a case of mobile phones to a European company that agreed to pay the U.S. manufacturer $10,000. The European company could exchange euros for dollars at a rate of $1.10 at the time the deal was finalized. It would cost them 9,090 euros to pay the $10,000 invoice ($10,000 / $1.10). We'll assume there were no changes in capital flows coming in and out of the U.S. that would also impact the dollar.

The U.S. dollar weakens before the payment due date, however, or it depreciates against the euro and the exchange rate suddenly moves to $1.14. It only costs the European company 8,772 euros to pay the $10,000 invoice ($10,000 / $1.14) as a result.

The European company paid the same $10,000 invoice but it saved 318 euros due to the exchange rate move between the time of the purchase and when the payment was made to the U.S. company. A depreciating dollar or a stronger, more expensive euro makes U.S. exported goods cheaper based solely on the exchange rate move.

The Bottom Line

It's important to note that the weaker dollar can eventually lead to an increase in demand for U.S. goods or exports from foreign companies. The dollar can eventually strengthen if the demand is strong enough because there's an increased demand for dollar-denominated exports. The exchange rate mechanism can lead to some moderation in the trade deficit as a result.