Trade deficit exists when a country spends more on importing goods and services than it receives for goods the country delivers and services it renders in other countries. For example, if India imports more products and services from China than it exports to China, India faces a trade deficit with China. Hence, the lower the trade deficit would mean there is a lesser need for India to import and that other countries are buying more Indian products and services.
Is trade bad for the economy?
According to economic theory, lasting trade deficit is detrimental to a nation’s economy but some economists who advocate for free markets suggest that negative effects of trade deficits will correct themselves over time. Famed economist Milton Friedman suggests that trade deficits, in the long run, are not always harmful as currency can come back to the country in the form of foreign investment instead of demand for exported products in foreign markets.
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How does trade deficit affect the economy?
Value of a country’s currency is closely linked to imports and exports but also affected by other factors. If India sells lesser exports in other countries, it results in lower demand for the Indian rupee, which decreases the price of the rupee. However, in a floating exchange rate system, if there is an increased demand for Indian products in export markets, the value of the INR should increase as demand increases.
Theoretically, as trade deficits increase, more jobs are lost to those abroad and hence it can increase the rate of unemployment but data from various economies show that unemployment is reliant on various other factors and hence unemployment may exist at high levels even if a country has a trade surplus.
In the balance of payments, trading factors into the current account, other components of the balance of payments are capital account and financial account. By definition, balance of payments is always a net zero. Hence if a country faces trade deficit, the country could have a higher amount of foreign ownership of government debt and foreign direct investment.
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How to reduce trade deficit?
Trade deficit can be lowered in several ways which are controlled by the Union Budget and other trade policies.
Depreciating currency value
Reducing the value of the Indian rupee would make Indian exports more competitive, increasing demand for Indian products. However, this would make imports more expensive and this measure has several other unpleasant side effects such as inflation and this measure is dependent on the elasticity of demand and hence is not an easy solution for decreasing trade deficit.
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Taxing inflow of capital to curb borrowing for consumption
Making excessive borrowing for consumption more expensive by placing taxes on non-FDI investment inflow of capital is a measure to close the imbalance but economists worry that controls on capital could reduce investment and alter prices of assets among other unpleasant effects.
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Implement policies that improve supply
Putting in place policies that improve competitiveness of the Indian economy and increase productivity, making exports more attractive and hence increasing demand for Indian products. Such solutions are widely considered as a better long-term fix for the trade deficit problem without causing any adverse effects than other solutions might have on the economy.
Protectionist quotas
Setting quotas on imports could reduce the amount of goods imported into the economy but as this is a barrier to free trade, it could be a violation of WTO rules. Further, other countries might retaliate by placing quotas on Indian exports and other measures that may be detrimental to Indian exports.