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.
The corresponding paper by Hakan Yilmazkuday has been accepted for publication at Journal of International Money and Finance.
The working paper version is available here.
Abstract
This paper proposes a decomposition for the total trade deficit of a country by using implications of a dynamic trade model. It is shown that the 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. The implications for bilateral trade are estimated using both imports and exports data for 188 countries, and the decomposition of total trade deficit is achieved for each country. Empirical results show evidence for heterogeneity across countries regarding the decomposition of trade deficits, suggesting alternative policy tools to rebalance trade at the country level. A cross-country investigation further suggests that relative trade costs have contributed the most to the heterogeneity of trade imbalances.
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, for example, 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 corresponding paper by Hakan Yilmazkuday has been accepted for publication at Journal of International Money and Finance. The working paper version is available here.