Accounting for Trade Deficits

One sentence summary: Total trade deficit of a country can be decomposed into changes due to its effective terms of trade, its relative trade costs, and its macroeconomic developments with respect to its export partners.

Non-technical Summary

Trade deficits (defined as the difference between imports and exports) have been experienced by more than 70% of the countries around the globe between 1980-2015. Having a trade deficit is problematic, because it is simply financed by capital flows (from trade-surplus countries) of which sudden stop can be destabilizing not only at the country level but also globally; on the other hand, having a trade surplus is also problematic, because trade-surplus countries may become targets for protectionist measures by trading partners. Accordingly, having a balanced trade (or at least not having an excessive deficit/surplus) is desirable for any open economy, which requires the knowledge of the sources of trade deficit.

This paper investigates the sources of trade deficit by using an international trade approach. In particular, based on the implications of a dynamic trade model that incorporates implicitly additively separable nonhomothetic constant elasticity of substitution (CES) preferences, the trade deficit of any country is decomposed into the effects due to changes in effective terms of trade, relative trade costs, and relative macroeconomic developments. This is achieved in two steps. First, by using the implications of the dynamic trade model, bilateral imports and bilateral exports of 188 countries are estimated. As is standard in the international trade literature, these estimations result in fitted values representing bilateral trade costs, source-time fixed effects and destination-time fixed effects for both bilateral imports and bilateral exports in logs. Second, since the sum of logs is not equal to the log of sums due to Jensen's inequality (i.e., one cannot take the sum of log bilateral trade deficits to obtain log total trade deficit), the fitted values obtained from these estimations are connected to the changes in total trade deficit of each country over time by using the Taylor series of bilateral trade expressions.?

This innovation results in a decomposition of the level changes in total trade deficit of a country based on changes in its effective terms of trade (representing the difference between the weighted average of import prices and the weighted average of export prices), changes in relative trade costs of the country (representing the changes in the weighted average of import trade costs and the weighted average of export trade costs), and relative macroeconomic developments of the country (representing ?changes in both relative economic activity and relative saving decisions with respect to its export partners). Since the sum of changes over time in the level of total trade deficit of any country is equal to its level of total trade deficit for any given period, a final decomposition can be achieved for the level of trade deficit for any country.

The empirical results suggest that each country has different patterns over time regarding the contribution of each gravity-based component in the decomposition of trade deficits, although relative trade costs followed by relative macroeconomic developments have contributed the most to the magnitude (of the trade deficit) during the sample period, on average across countries. The average OECD country has experienced a trade surplus that is mostly explained by effective terms of trade followed by relative macroeconomic developments, whereas the average non-OECD country has experienced a trade deficit that is mostly explained by relative trade costs followed by relative macroeconomic developments.

Regarding country-specific results, the U.S. trade deficit is mostly explained by the positive contributions of relative trade costs followed by those of effective terms of trade. In contrast, the negative Chinese trade deficit (i.e., its trade surplus) is mostly explained by its negative effective terms of trade, despite high and positive contributions of its relative macroeconomic developments. Another interesting country is Japan of which negative trade deficit (i.e., its trade surplus) is mostly explained by its relatively negative macroeconomic developments, followed by its negative relative trade costs.?

The paper is available at Journal of International Money and Finance.