Imports and exports may seem like prosaic terms that have little bearing on everyday life, but they exert a profound influence on the consumer and the economy. In today’s interlinked global economy, consumers are used to seeing products and produce from every corner of the world in their local malls and stores. These overseas products – or imports – provide more choices to consumers and help them manage strained household budgets. But too many imports in relation to exports – which are products shipped from a country to foreign destinations – can distort a nation’s balance of trade and devalue its currency. The value of a currency, in turn, is one of the biggest determinants of a nation’s economic performance. Read on to learn how these mundane staples of international trade have a more far-reaching influence than most people imagine.
Effects on the Economy
According to the expenditures method of calculating gross domestic product, an economy’s annual GDP is the sum total of C + I + G + (X – M), where C, I and G represent consumer spending, capital investment and government spending, respectively.
While all those terms are important in the context of an economy, let’s look closer at the term (X – M), which represents exports minus imports, or net exports. If exports exceed imports, the net exports figure would be positive, indicating that the nation has a trade surplus. If exports are less than imports, the net exports figure would be negative, and the nation has a trade deficit.
Positive net exports contribute to economic growth, something that is intuitively easy to understand. More exports mean more output from factories and industrial facilities, as well as a greater number of people employed to keep these factories running. The receipt of export proceeds also represents an inflow of funds into the country, which stimulates consumer spending and contributes to economic growth.
Conversely, imports are considered to be a drag on the economy, as can be gauged from the GDP equation. Imports represent an outflow of funds from a country, since they are payments made by local companies (the importers) to overseas entities (the exporters).
However, imports per se are not necessarily detrimental to economic performance, and in fact, are a vital component of the economy. A high level of imports indicates robust domestic demand and a growing economy. It’s even better if these imports are mainly of productive assets like machinery and equipment, since they will improve productivity over the long run.
A healthy economy, then, is one where both exports and imports are growing, since this typically indicates economic strength and a sustainable trade surplus or deficit. If exports are growing nicely but imports have declined significantly, it may indicate that the rest of the world is in better shape than the domestic economy. Conversely, if exports fall sharply but imports surge, this may indicate that the domestic economy is faring better than overseas markets. The U.S. trade deficit, for instance, tends to worsen when the economy is growing strongly. The country’s chronic trade deficit has not impeded it from continuing to be one of the most productive nations in the world.
But a rising level of imports and a growing trade deficit do have a negative effect on a key economic variable – the level of the domestic currency versus foreign currencies, or the exchange rate.
Effect of Exchange Rates
The inter-relationship between a nation’s imports and exports, and its exchange rate, is a complicated one because of the feedback loop between them. The exchange rate has an effect on the trade surplus (or deficit), which in turn affects the exchange rate, and so on. In general, however, a weaker domestic currency stimulates exports and makes imports more expensive. Conversely, a strong domestic currency hampers exports and makes imports cheaper.
Let’s use an example to illustrate this concept. Consider an electronic component priced at $10 in the U.S. that will be exported to India. Assume the exchange rate is 50 rupees to the U.S. dollar. Ignoring shipping and other transaction costs such as import duties for the moment, the $10 item would cost the Indian importer 500 rupees. Now, if the dollar strengthens against the Indian rupee to a level of 55, assuming that the U.S. exporter leaves the $10 price for the component unchanged, its price would increase to 550 rupees ($10 x 55) for the Indian importer. This may force the Indian importer to look for cheaper components from other locations. The 10% appreciation in the dollar versus the rupee has thus diminished the U.S. exporter’s competitiveness in the Indian market.
At the same time, consider a garment exporter in India whose primary market is the U.S. A shirt that the exporter sells for $10 in the U.S. market would fetch her 500 rupees when the export proceeds are received (again ignoring shipping and other costs), assuming an exchange rate of 50 rupees to the dollar. But if the rupee weakens to 55 versus the dollar, to receive the same amount of rupees (500), the exporter can now sell the shirt for $9.09. The 10% depreciation in the rupee versus the dollar has therefore improved the Indian exporter’s competitiveness in the U.S. market.
To summarize, a 10% appreciation of the dollar versus the rupee has rendered U.S. exports of electronic components uncompetitive, but has made imported Indian shirts cheaper for U.S. consumers. The flip side of the coin is that a 10% depreciation of the rupee has improved the competitiveness of Indian garment exports, but has made imports of electronic components more expensive for Indian buyers.
Multiply the above simplistic scenario by millions of transactions, and you may get an idea of the extent to which currency moves can affect imports and exports. Countries occasionally try to resolve their economic problems by resorting to methods that artificially depress their currencies in an effort to gain an advantage in international trade. One such technique is “competitive devaluation,” which refers to the strategic and large-scale depreciation of a domestic currency to boost export volumes. Another method is to suppress the domestic currency and keep it at an abnormally low level. This is the route preferred by China, which held its yuan steady for a full decade from 1994 to 2004, and subsequently allowed it to appreciate only gradually against the U.S. dollar, despite having the world’s biggest trade surpluses and foreign exchange reserves for years.
Effect of Inflation and Interest Rates
Inflation and interest rates affect imports and exports primarily through their influence on the exchange rate. Higher inflation typically leads to higher interest rates, but does this lead to a stronger currency or a weaker currency? The evidence is somewhat mixed in this regard.
Conventional currency theory holds that a currency with a higher inflation rate (and consequently a higher interest rate) will depreciate against a currency with lower inflation and a lower interest rate. According to the theory of uncovered interest rate parity, the difference in interest rates between two countries equals the expected change in their exchange rate. So if the interest rate differential between two nations is 2%, the currency of the higher-interest-rate nation would be expected to depreciate 2% against the currency of the lower-interest-rate nation.
In reality, however, the low-interest-rate environment that has been the norm around most of the world since the 2008-09 global credit crisis has resulted in investors and speculators chasing the better yields offered by currencies with higher interest rates. This has had the effect of strengthening currencies that offer higher interest rates. Of course, since such “hot money” investors have to be confident that currency depreciation will not offset higher yields, this strategy is generally restricted to stable currencies of nations with strong economic fundamentals.
As discussed earlier, a stronger domestic currency can have an adverse effect on exports and on the trade balance. Higher inflation can also affect exports by having a direct impact on input costs such as materials and labor. These higher costs can have a substantial impact on the competitiveness of exports in the international trade environment.
A nation’s merchandise trade balance report is the best source of information to track its imports and exports. This report is released monthly by most major nations. The U.S. and Canada trade balance reports are generally released within the first 10 days of the month, with a one-month lag, by the Commerce Department and Statistics Canada, respectively. These reports contain a wealth of information, including details on the biggest trading partners, the largest product categories for imports and exports, trends over time, etc.
Imports and exports exert a major influence on the consumer and the economy directly, as well as through their impact on the domestic currency level, which is one of the biggest determinants of a nation’s economic performance.
More From Investopedia
- Budget, Tax & Economy
- exchange rate