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FABSF WEEKLY LETTER March 11, 1988 The Persistent Trade Deficit In the last year, U.S. real net exports improved by over $20 billion. Nevertheless, given the sharp depreciation of the dollar since 1985, many analysts remained disappointed. In fact, concern has arisen about the extent to which depreciation in the value of the dollar will generate the strong trade improvement that many have anticipated. Some argue that, in the past, income effects rather than exchange rate changes were the major cause of improvements. Without a U.s. recession to slow import demand and/or significantly stronger foreign income growth to spur exports, they assert, current expectations of a significant turnaround are unwarranted. This Letter compares the current contributions of income and exchange rate changes to trade balance projections with those during earlier episodes of u.s. trade balance adjustment. Determinants of net exports The major determinants of a country's trade balance, according to economic theory, are the exchange rate and domestic and foreign income growth. When the value of a country's currency falls, all other things considered, the country's exports become cheaper and easier to sell. At the same time, imports into the country become expensive and harder to sell. Of course, it takes time for changes in currency values to affect trade flows because it takes time for prices to reflect exchange rate changes and for buyers to adjust the quantities to which preexisting contracts had committed them in the short-run. Suppliers may also require a substantial amount of time to change their production levels. Domestic and foreign income changes are the other major determinants of trade flows. Higher income growth and economic activity abroad increase demand for a country's exports, while greater domestic income growth leads to higher imports. Chart 1 plots the evolution from the fourth quarter of 1972 through the fourth quarter of 1988 of the real net export balance, both with and without oil imports. The figures shown for the period from 1987Q4 to 1988Q4 are projections derived in a manner described below. The shaded areas mark two past episodes of strong trade balance improvement: (i) 1972Q4 to 1975Q2 and (ii) 1978Q1 to 1980Q3, as well as the period of improvement that began in 1986Q4 and is projected to continue at least through 1988Q4. Each of these periods is approximately two-and-a-half years in length. The magnitude of cumulative actual improvement in the earlier periods and of projected improvement through the end of this year are roughly equal at $80 to $90 billion dollars. Chart 2 plots the real trade-weighted value of the dollar over the same period. It shows that the dollar depreciated during each of the two earlier episodes of trade balance improvement, and depreciated most sharply in the most recent period. Thus, significant U.s. trade balance improvements have in the past corresponded to a depreciating dollar. Chart 3 plots two-quarter moving average GNP growth rates for both the U.S. and the rest of the· world (the latter proxied by a weighted average of rates in several industrial countries). It shows that world growth generally exceeded that in the u.s. over the two prior periods of trade balance improvement - 1972Q4 to 1975Q2 and 1978Q1 to 1980Q3. In contrast, in the last year, U.s. growth has exceeded that abroad. This suggests that in the current period, income effects may be working against improvement in the U.s. trade balance. Contribution of income and price effects A more precise determination of how much of the adjustment in the trade balance is attributable to price changes versus income changes on average can be obtained from statistical estimates of the historical relationship between trade balance flows and their major determinants --- the exchange rate and u.s. and world GNP. FRBSF In particular, historical relationships were estimated for real exports and real nonpetroleum imports of goods and services using data from the fourth quarter of 1972 to the third quarter of 1987. Petroleum imports were removed because of the changeability of OPEC pricing practices and the relative unresponsiveness of oil imports to changes in U.s. dollar exchange rates (because oil generally is invoiced in dollars). Exchange rate changes were allowed to affect trade flows with a lag. The resulting estimated historical relationships were then used to generate projections of trade balance adjustment over the period 1987Q4 to 1988Q4 using projections of a cumulative 10 percent fall in the value of the dollar, 2.2 percent average growth in the United States, and 2 percent average growth abroad. The general conclusions discussed below are unaffected by plausible alterations in these projections. With these estimates of the relationship between exports and nonoil imports, on the one hand, and income and price variables, on the other, it is possible to decompose the cumulative change in the nonoil net export balance over each of the periods above into components attributable to (i) income changes, (ii) relative price changes, and (iii) prediction errors. Income changes represent the combined effects of U.s, real GNP growth on our imports and of world GNP growth on our exports. Relative price effects represent the combined effects of changes in the real price of the dollar on both exports and imports. The prediction errors arise from changes in the actual balance unexplained by income and price effects on the basis of the historical relationships estimated over the period 1972Q4 to 1987Q3. The results of thisexercisefor th.e three periods of real net export balance. improvement were as follows. Over.the two earlier periods, 1972Q4 to 1975Q2 and1978Q1 to 1980Q3, income and price effects worked in the same direction and each accounted for roughly forty percent of the improvemellL(Predictipnerrors account for the rest.) Thus, during those episodes, a depreciating dollar. and relativelyslower growth in the United States than abroad contributed equallytoreducilJgour trade deficit. In contrast, Jor the period ·.1 986Q4-1988Q4, income and price effects appear to be working in opposite directions. Specifically, because for~ eign income is not growing fast enough relative to U.S. income to expand the growth of exports relative to our imports, income effects currently make a negative forty percent contribution to the overall improvement in the trade balance; i.e., they are working against improvement in the trade balance. However, past, current,and projected exchange rate and price changes are estimated to account for one hundred forty percent of the trade balance improvement. In other words, the effects of exchange rate and price changes are estimated to more than offset the negative income effects. This relative role of price and income factors, which underlies current projections of trade balance adjustment, contrasts with previous experience. While the role of changes in relative prices underlying current projections of trade balance improvement is significantly greater than has been the case before, the more-than-fifty percent depreciation of the dollar over the past two years has been much greater than previously experienced. Assuming that a given relative price change has near the same impact on trade flows in the future as it has had in the past, a depreciation of this magnitude can be expected to improve the trade balance considerably. Conclusions In earlier instances of u.s. trade balance improvement, income and relative price effects worked in the same direction and played roughly equal roles. Current projections of a strong trade balance turnaround attribute a significantly greater role to relative price changes associated with recent dollar depreciations than was the case in the earlier episodes. Moreover, income effects are now working against improvement in the trade balance. Nevertheless, the real trade .balance has improved in recent quarters, and further expected improvement is consistent with the sharp depreciation of the dollar since 1985. An improving trade picture should contribute to stronger U.s. economic growth. In the past year, the improvement in the trade balance has contributed roughly a half percentage point to GNP growth. Further improvement is an importalJt factor in the forecast ofcontinued expansion of the economy through 1988. Reuven Glick Chart 3 Chart 1 U.S. Real Net Exports* $Sillions 1982 200 160 120 80 40 10 8 6 4 2 o o -40 -2 -80 -120 -160 -200 -4 -6 -8 1973 1975 1977 1979 1981 1983 1985 1987 1973=100 1973 1975 1977 1979 1981 1983 1985 1987 • 198704 - 198804 forecast • 198704 - 198804 forecast 140 GNP Growth Rates* Percent Chart 2 U.S. Real Trade-Weighted Exchange Rate* 130 120 110 100 90 80 70 1973 1975 1977 1979 • 198704 - 198804 forecast 1981 1983 1985 1987 Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of G.overnors of the Federal Reserve System. Editorial comments may be addressed to the editor (Gregory Tong) orto the author .... Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246. uo~6u!4S0m 040PI 4o~n U060JO !!omoH O!UJoJ!l0) OpOA0U ouoz!J~ O)SI)UOJ::f o~sol~ uos JO ).fUOa aAJaSa~ IOJapa::f ~uaw~Jodaa lpJOaSa~ BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Loans, Leases and Investments1 2 Loans and Leases 1 6 Commercial and Industrial Real estate Loans to Individuals Leases U.S. Treasury and Agency Securities 2 Other Secu rities 2 Total Deposits Demand Deposits Demand Deposits Adjusted 3 Other Transaction Balances4 Total Non-Transaction Balances 6 Money Market Deposit Accounts-Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed MoneyS Two Week Averages of Daily Figures Reserve Position, All Reporting Banks Excess Reserves (+ )/Deficiency (-) Borrowings Net free reserves ( + )/Net borrowed( - ) Amount Outstanding 2/17/88 203,839 180,707 51,439 70,819 36,069 5,776 16,078 7,054 204,253 51,102 31,341 20,137 133,013 from 2/10/88 - - - 43,527 33,065 24,185 Change from 2/18/87 Dollar PercenF Change - - 0.5 2.2 3.7 6.0 - 10.9 7.4 22.7 2.7 0.0 1.3 - 33.8 5.9 0.2 367 - 3,521 - 7.5 388 2,364 1,546 3,975 - - - 4.9 14.1 Period ended Period ended 2/8/88 1/25/88 98 9 90 130 11 119 1 Includes loss reserves, unearned income, excludes interbank loans 2 Excludes trading account securities 3 Excludes government and depository institution deposits and cash items 4 ATS, NOW, Super NOW and savings accounts with telephone transfers S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources 6 Includes items not shown separately 7 Annualized percent change u.s. J - 1,044 4,218 - 1,998 4,058 4,452 398 2,983 192 64 687 - 16,073 1,132 383 251 186 575 46 150 12 62 4 2,008 2,054 2,342 4 51 -
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