Understanding the Trade Deficit–Foreign Investment Relation

The fundamental economic principles that explain the correlation between trade deficits and foreign investments. The core concept lies in the Balance of Payments (BoP) accounting identity.

1. The Balance of Payments (BoP):

   • Every country tracks its economic transactions with the rest of the world, a record called the Balance of Payments.
   • The BoP is fundamentally divided into two main accounts (simplified):
     • Current Account: Primarily tracks the trade in goods and services (Exports - Imports = Trade Balance), plus income flows (like dividends from foreign investments) and transfers (like foreign aid). A trade deficit means the country imports more goods and services than it exports, contributing to a current account deficit.
     • Capital and Financial Account (often just called Capital Account for simplicity): This account tracks the flow of investments into and out of the country. This includes foreign direct investment (FDI—buying physical assets like factories) and foreign portfolio investment (FPI—buying financial assets like stocks and bonds). A surplus in this account means more foreign investment flows into the country than domestic investment flows out.

2. The BoP Must Balance:

   • This is the crucial accounting identity: Current Account Balance + Capital/Financial Account Balance = 0 (ignoring minor statistical discrepancies).
   • Think of it as double-entry bookkeeping for a country. Every dollar that leaves the country (e.g., to pay for an import) must be matched by a dollar coming into the country (e.g., from an export or a foreign investment), or vice versa.

3. The Direct Link:

   • Suppose a country has a Current Account deficit (mainly driven by a trade deficit where Imports > Exports). In that case, it means the country is spending more on foreign goods, services, and assets than it is earning from selling its own goods, services, and assets abroad.
   • To satisfy the BoP identity (Balance = 0), a Capital/Financial Account surplus must offset this Current Account deficit.
   • A Capital/Financial Account surplus means net foreign investment flows into the country. Foreigners are investing more in the country (buying its assets like stocks, bonds, real estate, and companies) than residents of the country are investing abroad.

4. The Mechanism (How it Works in Practice):

   • Paying for Imports: When a country (like the US) imports more than it exports, it sends more of its currency (e.g., US dollars) abroad to pay for those imports than it receives back from selling exports.
   • Foreigners' Use of Currency: What do foreigners do with their accumulated excess dollars? They don't just hold them indefinitely. They use them to buy assets in the country that issued the currency. They might buy US Treasury bonds, US stocks, US companies, or US real estate. This act of buying US assets constitutes foreign investment into the US.
   • Financing the Deficit: This inflow of foreign capital (foreign investment) effectively finances the trade deficit. The dollars that flowed out to pay for imports flow back in as foreign investment, balancing the payments.

5. Savings, Investment, and Trade:

   • Another related fundamental concept comes from national income accounting: Savings (S) - Investment (I) = Current Account Balance (CAB) (approximately equal to Net Exports or Trade Balance).
   • If a country's domestic investment (I) is greater than its domestic savings (S), it means it isn't saving enough to fund its investment opportunities.
   • The country must borrow from abroad to fund this gap (I > S). This borrowing takes the form of foreign capital inflows (a Capital Account surplus).
   • According to the identity, if (S-I) is negative (because I > S), then the Current Account Balance (CAB) must also be negative, implying a trade deficit.
   • So, a country that invests more than it saves domestically will typically run a trade deficit and finance it with foreign investment inflows.

Summary:

The correlation between trade deficits and foreign investment isn't just a coincidence; it's a result of the balance of payments' fundamental accounting identity. A trade deficit (part of a current account deficit) signifies that a country buys more from the world than it sells. This difference must be financed, and that financing comes primarily through net inflows of foreign capital (foreign investment), which show up as a surplus on the capital/financial account. These two accounts must mathematically offset each other.

References:

Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2022). International economics: Theory and policy (12th ed.). Pearson.   

Relevance: This widely used textbook provides a comprehensive explanation of open-economy macroeconomics, including detailed chapters on the Balance of Payments accounts, the relationship between the current account and financial account, and how trade balances relate to international capital flows.

International Monetary Fund. (2009). Balance of Payments and International Investment Position Manual (6th ed.). IMF Publications. https://www.imf.org/external/pubs/ft/bop/2007/pdf/bpm6.pdf   

Relevance: This manual is the standard international guideline for compiling Balance of Payments statistics. It defines the current account, capital account, and financial account and lays out the double-entry accounting system that requires the balance between these accounts, fundamentally linking trade flows and investment flows.   

Mankiw, N. G. (2023). Principles of macroeconomics (10th ed.). Cengage Learning.

Relevance: Foundational undergraduate textbook chapters on open-economy macroeconomics explain the concepts of net exports and net capital outflow, the identity linking savings, investment, and international flows (S—I = NCO/CAB), and how trade deficits are financed by inflows of foreign investment (net capital inflow).