Explain why it is important for a government to avoid running a large and prolonged trade surplus or deficit.
a. Explain why it is important for a government to avoid running a large and prolonged trade surplus or deficit. [10]
Introduction
The balance of trade, a key component of a country’s current account, represents the difference between the value of exports and the value of imports of goods and services. When export earnings exceed import expenditure, the country is said to be running a trade surplus. Conversely, a trade deficit occurs when import spending outstrips export revenues. While short-term imbalances in trade are not uncommon and can even be beneficial under certain conditions, large and persistent trade surpluses or deficits can signal deeper economic problems and may result in undesirable consequences for long-term economic stability and growth.
Why Governments Should Avoid Large and Persistent Trade Deficits
A persistent trade deficit often reflects structural weaknesses in an economy’s ability to compete globally. If a country consistently imports more than it exports, it may signal that domestic producers are losing ground to foreign competitors. This could be the result of high unit labour costs, low productivity, outdated production techniques, or weak innovation ecosystems. Over time, this dependence on imports can hollow out key domestic industries, resulting in deindustrialisation and increased unemployment in affected sectors. For example, if local manufacturing cannot match the cost or quality of foreign goods, consumers and businesses may turn increasingly to imports, undermining the viability of domestic firms.
Beyond competitiveness, persistent trade deficits place pressure on a country’s foreign exchange reserves. Since imports must be paid for in foreign currencies, prolonged deficits require the central bank to draw down its reserves to finance the gap. If these reserves are substantially reduced, the country may have to resort to external borrowing, which not only increases foreign debt but also exposes the country to exchange rate risks and sovereign credit downgrades, especially if lenders perceive the trade deficit as unsustainable.
Additionally, sustained trade deficits can exert downward pressure on the domestic currency. As demand for foreign currencies rises (to pay for imports) and demand for the domestic currency falls (due to fewer exports), the exchange rate depreciates. While depreciation can theoretically make exports cheaper and improve the trade balance, it also raises the cost of imports, particularly essential goods like food, energy, and intermediate inputs. The result is imported inflation, which erodes real incomes, raises business costs, and can lead to a cost-push inflationary spiral—deepening the challenges for both consumers and producers.
Why Governments Should Avoid Large and Persistent Trade Surpluses
While trade surpluses are often viewed as more desirable than deficits, large and prolonged surpluses come with their own set of issues. A persistent surplus may reflect weak domestic consumption and insufficient investment in imported goods, which can lead to suboptimal living standards. In economies where consumption is low relative to output, it could mean that citizens are not fully enjoying the fruits of economic growth. For example, if households rarely purchase imported consumer goods—such as foreign electronics, educational services, or luxury items—it may indicate a low domestic standard of living, even when national income appears high.
Furthermore, excessive reliance on export-led growth—often the cause of sustained trade surpluses—can create economic imbalances. It ties the country’s fortunes closely to the economic health of external markets. A downturn in key trading partners could sharply reduce export demand, triggering a domestic slowdown. For example, Singapore’s export-reliant economy is highly sensitive to global economic cycles, which is why it remains cautious about overdependence on trade surpluses.
Persistent surpluses can also trigger international political and economic tensions. Trading partners may view a country’s large surplus as evidence of currency manipulation or unfair trade practices, particularly if the country is suspected of keeping its currency undervalued to make its exports more competitive. This can lead to retaliatory protectionist measures such as tariffs or quotas. A notable example is the U.S.–China trade tensions, where the U.S. accused China of running artificially large surpluses by undervaluing the yuan. The result was a prolonged trade conflict, with mutual tariffs that ultimately harmed businesses and consumers on both sides.
Conclusion
In conclusion, while trade imbalances are not inherently problematic in the short run, large and persistent trade surpluses or deficits can have damaging long-term effects on an economy. Trade deficits risk undermining domestic industry, depleting foreign reserves, raising external debt, and fuelling imported inflation. On the other hand, trade surpluses, though less immediately alarming, may reflect underconsumption, risk foreign backlash, and overexpose the economy to external shocks. It is thus important for governments to monitor and manage trade balances prudently, striving for a position that supports both domestic resilience and external sustainability
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