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The usual answer is either "foreign debt" or "Foreign Direct Investment". But:

  • Why does that make sense?

  • And why wouldn't be financed otherwise like from importers taking out bank loans domestically rather than from foreigners?

  • Finally, it is said that a trade deficit can be financed by Foreign Direct Investment because the domestic currency given in exchange for the imports can only be spent back into the importing country. How does this work when whoever we're importing from is paid in THEIR currency rather than the domestic currency of the importer?

I hope someone more knowledgeable can help me out. Thanks.

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Natural resources and gravity determines trade. How the balance of payments is settled is not really important. But there are a few possibilities

  • a country has a lot of debt and defaults or refis it down to a very low rate to go negative indefinitely;

  • foreign aid;

  • moneyprinting that isn't adequately adjusted in foreign exchange;

  • selling overpriced domestic assets that are not properly accounted in the bop records;

  • stealing things

An example of 1 would be any debt crisis.

For 3 for example, Zimbabwe was trade deficit during it's episode

For 4, US startup equity is boosting it's balance of payments. It is not fdi or portfolio investment and includes travel expenses and things not adequately tracked;

For 5, any sort of anti western government expropriating assets, like Zimbabwe, uses that to fund it's balance of payments.

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This can be visualized nicely by an example:

Let’s say there are two islands in the world. And let’s just say island A only produces apples and island B only produces bananas. Also, the (real) exchange rate is one apple for one banana.

Now, for whatever reason, island A exports 20 apples but imports 30 bananas (a trade deficit). It now owes goods of the value of 10 apples/bananas to island B. How can it serve this debt? (If it were to send goods to the other island, its exports would rise by definition, and the trade deficit would disappear.) Instead, island A makes a promise to pay back the debt in a later period to island B (foreign debt). Instead of debt contracts, island B can also trade the excess bananas for shares in the production of A of the same value, which is equivalent.

Regarding question 2: A domestic loan has by definition a borrower and a lender on the same island. This always nets out to zero debt when aggregated to the island level. Hence, it can’t change the island’s debt position vis-à-vis another island.

Regarding question 3: Note that so far, we haven’t even mentioned money. The trade effects can be entirely explained by real variables. If we introduce currencies on both islands, there must be a foreign exchange market. This market for currency only clears if the exchanged currencies are of equal value (in real terms). It does not matter if you pay in the producer’s or the buyer’s currency, the currency for buying 30 bananas is always of higher real value than the currency to buy 20 apples. Demand and supply of currency won’t cancel out, so the foreign exchange market does not help you to settle the debt.

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