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

During a trade deficit, the U.S. dollar has depreciated or weakened, but in many other instances, the dollar has strengthened. There are numerous variables that drive exchange rates in addition to the balance of payments, including 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 means that the United States is buying more goods and services from abroad (importing) than it is selling abroad (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 must import those goods. Countries might also lack a skilled workforce to manufacture their own goods, and as a result, are dependent on more developed nations. Other times, a trade deficit can be due, in part, to foreign goods being cheaper than the domestically-produced goods.

Imports

If imports continue to exceed exports, the trade deficit can worsen, leading to more outflows of U.S. dollars. In other words, the foreign imports, which are purchased by U.S. consumers, are paid for by exchanging U.S. dollars into the foreign currency of the international company. So, if imports are rising, there can be an increase in the aggregate amount of dollars leaving the country.

Exports

Conversely, if a foreign company buys U.S. exports, they exchange their local currency for dollars to facilitate the purchase–leading to more demand for dollars. However, if exports are falling, it means there is less demand for U.S. goods by foreigners. 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. However, as the dollar weakens, U.S. exports become cheaper to foreigners because they can get more U.S. dollars for the same amount of their currency to buy American goods. Even though the price of the exported goods hasn't changed, foreigners essentially can buy U.S. goods at a discount when the dollar is weaker.

The increased demand for U.S. exports leads to more foreign currencies being exchanged for dollars, which increases the dollar exchange rate relative to the currencies involved. The result (in theory) should be a trade deficit that is brought back into balance. However, in reality, it seldom works out that neatly since the demand–or lack of demand–for a country's goods is driven by other factors besides 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 has not translated into significant dollar weakness as would be expected. 

Below are some of the reasons why the dollar has maintained its strength over the years despite trade deficits.

The Dollar's Reserve Currency Status

The U.S. dollar is the world's reserve currency, meaning it's used to facilitate transactions in trade, by central banks, and by corporations. Emerging market economies, for example, typically price their government bonds or debt in dollars because usually developing countries' currencies are not stable. Also, many commodities are priced in dollars, including gold and crude oil. All of 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, which 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.

As a result, the dollar often strengthens when foreign investment enters the U.S. All of 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 because it can, but it's difficult to pinpoint whether any weakness is solely caused by an increase in imports or a decline in U.S. exports. The dollar's reserve currency status and the capital flows that come in and out of the U.S. also impact the dollar, making it difficult to determine what's the primary cause of any dollar strength or weakness.

Major economies that issue their own currency—such as the United Kingdom, India, and Canada—are in a similar space, where they can run persistent trade deficits. Countries that do not 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

Below is an example of how the dollar exchange rate can impact foreign trade. For illustrative purposes, we'll assume there were no changes in capital flows coming in and out of the U.S., which would also impact the dollar.

For example, let's say a company sold a case of mobile phones to a European company, which agreed to pay the U.S. manufacturer $10,000. At the time the deal was finalized, the European company could exchange euros for dollars at a rate of $1.10, meaning it would cost them 9,090 euros to pay the $10,000 invoice ($10,000 / $1.10).

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

The European company paid the same $10,000 invoice but 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. In other words, a depreciating dollar (or stronger, more expensive euro) makes U.S. exported goods cheaper based solely on the exchange rate move.

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. If the demand is strong enough, the dollar can eventually strengthen since there's an increased demand for dollar-denominated exports. As a result, the exchange rate mechanism can lead to some moderation in the trade deficit.