The Trade Balance of a country is = its Net Export (Export - Import) of goods and services. It’s taught in school and colleges that net exports of a country are necessarily = its net international capital outflow. In this post, I will explain the logic behind this statement, hopefully in a way that henceforth, this statement will appear to be truism. (Which it is, but it usually never feels like that, since it’s often misunderstood or poorly explained).
In an open economy (which trades with other nations),
Y = C + I + G + NX - (1)
Where C = Consumption, I = Investment, G = Government spending and NX = Net exports i.e. Exports - Imports.
This is the National Income Identity that always holds true.
Re-arranging (1) we get:
Y - C - G - I = NX
Where Y - C - G = S (National Saving)
So, S - I = NX - (2)
i.e. Saving in the economy less investment in the economy = Net Exports of the economy.
Now, if Saving is > Investment, then capital (the excess saving) will flow out of the country. Similarly, if Investment > Saving, this means capital has flown into the country. (How else would investment be > saving?)
So, S - I = Net International Capital outflow - (3)
Substituting (3) in (2) gives us:
Net Exports = Net Capital Outflow
Per the National Income Identity, we now know that Net Exports = Net Capital Outflow. Buy why? What is the logic behind this statement? Let me explain with an example.
Let’s suppose that TCS (Indian technology company) sells IT services to a client in the US. It gets paid 10,000 USD for its services. I will now explain how no matter what happens with these 10,000 US dollars, net exports for India will always be = net capital outflow.
1. TCS invests the 10,000 USD in the American stock market.
When TCS invests the 10,000 USD it has received for its exports into the American stock market, it is investing in an American financial asset - the stock of an American company. Capital is flowing out of India into the US. Hence, India’s net exports are = its net capital outflow.
2. TCS just holds on to the 10,000 USD i.e. hoards it.
When TCS holds on to the 10,000 USD, it is in essence made an investment in American currency. It is holding USD - an American financial asset. This still amounts to a capital outflow from India (into America). So, net exports for India are again = its net capital outflow.
3. TCS uses the 10,000 USD to pay its employees in the US.
When TCS uses the 10,000 USD to pay the salaries of its employees in the US, it is importing services from the US. The 10,000 USD it received for its exports are spent in paying for imports, so net export = 0. The capital outflow that happened when TCS exported its IT services and was paid USD 10,000 is also reversed because when TCS pays its US employees 10,000 USD as compensation, it liquidates its investment in USD. Hence, net capital outflow from India = 10,000 USD - 10,000 USD = 0. Net exports are again = net capital outflow = 0.
4. What if TCS was paid for its exports in Rupees instead of USD?
If TCS was paid by its US client in Rupees (INR) instead of USD, it would receive ~ Rs. 6,60,000 (we assume exchange rate of Rs 66/USD) for its export of IT services. Does the identity still hold? Yes.
When the client pays TCS in INR, it means that the US had an investment in Indian currency (i.e. there was a capital inflow into India), which has now been liquidated in order to pay for US imports. This means the capital inflow into India has fallen by Rs. 6,60,000 or alternatively, there’s been a capital outflow from India worth Rs. 6,60,000. Net exports are again = Net capital outflow = Rs, 6,60,000 (or 10,000 USD).
5. What if TCS decides to exchange its USD for INR after it is paid in USD?
Lets suppose after TCS gets 10,000 USD from its US client in return for its services, TCS decides it wants INR instead. So the company goes to a bank and exchanges its 10,000 USD for 6,60,000 INR. What happens now? Nothing different really. Instead of TCS holding the USD, an Indian bank is now holding USD. India has still made an investment in USD. Capital has still flow out of India. Net export is still = net capital outflow.
Bottom-line: Whatever scenario one chooses to look at, Net Exports are always = Net Capital Outflow.
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