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A nation is said to run a trade deficit when it buys more goods and services from abroad than it sells to other nations. As a broad rule, a trade deficit is undesirable, but it may take a long time for the ill effects of a deficit to actually drag down stock prices. The trade deficit of a particular economy and its likely impact on the nation's stock market must be carefully evaluated within the right context.
A trade deficit occurs when the value of imports of a nation exceed that of its exports. If exports are larger, the nation is said to run a trade surplus. A nation imports if it buys something from another country; it exports when it sells to another nation. Goods as well as services count. When an Australian pays a dollar to an American site to download a song, America's exports grow. The trade deficit or surplus does not account for some money flows, such as investment income and money transfers. The broader measure in trade analysis, including such things as money sent via bank transfers, is called the "current account." The current account balance is almost always a similar figure to the trade balance, since trade accounts for the bulk of money flow.
If a country is running a sustained trade deficit, it is sending more currency abroad than it is taking in. Since international trade is conducted by exchanging only a few currencies, such as the American dollar and euro, the nation with a sustained deficit will at some point run out of those currencies. When that happens, the dollars or euros in that nation will become more scarce, and their value will climb. If Turkey is running a constant deficit, for example, the value of the Turkish lira against the dollar may go from two-to-one to three-to-one. This will make foreign goods coming from abroad more expensive in Turkey, and Turkish goods exported to foreign countries cheaper, as quoted in local currencies abroad. Consequently, imports should decline, exports increase, and the deficit disappear.
America is in a unique situation as the dollar, along with the euro, is one of the two major mediums for international trade.Therefore, when running a trade deficit, the country can simply print dollars and send them abroad to buy what it needs -- but a nation cannot print more currency indefinitely without disrupting economic balances. The basic laws of supply and demand dictate that too much of anything makes that thing eventually less desirable. Too much money will result in the erosion of the purchasing power of money, leading to higher prices. In short, inflation will ensue if a nation like America resorts to printing money to cope with its trade deficit.
If inflation rears its ugly head in America, stock prices in the nation will likely decline. High inflation leads to rising interest rates. This makes borrowing money for long-term investments more expensive for corporations, which have to expend a great portion of their profits towards interest payments on loans. Higher interest rates also lift up mortgage rates, interest payable on consumer loans, and credit card debt. This curbs purchases by consumers and results in lower sales for companies. The combination of these factors further depresses corporate profits, pushing many companies into net losses and some into bankruptcy. Not surprisingly, stock prices tend to significantly decline in such an environment.
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