Union Budget 2021 | What is trade deficit? How can it be controlled?

Finance Minister Nirmala Sitharaman is set to present a crucial Budget on February 1, 2021. The Budget will outline the economy's road to recovery in the post-Covid-19 world.

The Budget comes against the backdrop of an expected economic contraction of 7.7 per cent - the first time in the history of independent India.

With the upcoming Budget just around the corner, let us understand some of the terms related to the annual exercise.

What is a trade deficit?

If a country imports more goods and services than it exports in a given period of time, then such a situation is called a trade deficit. A trade deficit is also known as a negative trade balance.

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For example, if India imports more products and services from China than it exports to the neighbouring country, India faces a trade deficit with China. Hence, a lower trade deficit would mean there is a lesser need for India to import and that other countries are buying more Indian products and services.

Is trade deficit bad for the economy?

While a section of economists believe a lasting trade deficit is detrimental to a nation’s economy, some economists who advocate for free markets suggest that negative effects of trade deficits will correct themselves over time. Milton Friedman, who won a Nobel Memorial Prize in Economic Sciences, argued that trade deficits, in the long run, are not always harmful as currency can come back to the country in the form of foreign investment rather than demand for exported products in foreign markets.

How does the trade deficit affect the economy?

The value of a country’s currency is closely linked to imports and exports among other factors. If a country has a smaller export footprint, it results in lower demand for the domestic currency. In the case of India, a higher trade deficit may reduce the value of the rupee against the US dollar. However, in a floating exchange rate system, if there is an increased demand for Indian products in export markets, the value of the rupee should increase as demand increases.

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Theoretically, as the trade deficit increases, more jobs are lost to those abroad, which can increase the rate of unemployment. Data from various economies, however, show that unemployment is reliant on various other factors and hence unemployment may exist at high levels even if a country has a trade surplus.

How can the trade deficit be reduced?

The trade deficit can be lowered in several ways which are controlled by the Union Budget and other trade policies. Here are some of the ways one can tackle the trade deficit:

> Depreciating currency value

Currency devaluation is a deliberate downward adjustment of the value of a country's currency against another currency. Reducing the value of the Indian rupee would make Indian exports more competitive, increasing demand for Indian products. However, this would make imports more expensive and this measure has several other unpleasant side effects such as inflation and this measure is dependent on the elasticity of demand and hence is not an easy solution for decreasing trade deficit.

> Taxing inflow of capital to curb borrowing for consumption

Making excessive borrowing for consumption more expensive by placing taxes on non-FDI investment inflow of capital is a measure to close the imbalance but economists worry that controls on capital could reduce investment and alter prices of assets among other unpleasant effects.

> Protectionist quotas

Setting quotas on imports could reduce the number of goods imported into the economy but as this is a barrier to free trade, it could be a violation of WTO rules. Further, other countries might retaliate by placing quotas on Indian exports and other measures that may be detrimental to Indian exports.