What Is Dollar Drain?
A dollar drain is when a country imports more goods and services from the United States than it exports back to the U.S. The net effect of spending more money importing than is received from exporting causes a net reduction in the total U.S. dollar reserves of that country.
The concept can be applied to other countries and their respective currencies.
- A dollar drain is when a country imports more goods and services from the United States than it exports back to the U.S. It is in essence, a trade deficit.
- A dollar drain makes it difficult for policymakers at the central bank of the country in question to control the supply of money, which can reduce their ability to intervene in the economy.
- Dollar drain is related to the phenomenon of hot money flows that were at least partially responsible for the Asian Financial Crisis in 1997.
Understanding a Dollar Drain
A dollar drain is, in essence, a trade deficit. For example, if Canada has exported $500 million worth of goods and services to the U.S. and has also imported $650 million worth of goods and services from the U.S., the net effect will be a reduction in Canada's U.S. dollar reserves.
A dollar drain position should not be maintained indefinitely. As a result of the laws of supply and demand, importing more than is exported may cause a devaluation of the importing country's currency. However, this effect will be mitigated if foreign investors pour their money into the importing country's stocks and bonds, as these actions will increase the demand for the importing country's currency, causing it to appreciate in value.
Examples of Dollar Drain, Devaluation, and Economic Policy
The risk of a dollar drain is the effect it has on monetary policy. To handle monetary policy, central banks outside the U.S. and particularly central banks of developing and emerging economies require a substantial amount of currency reserves to stabilize their own currencies. If there is a shortage of reserves, the central bank may have a harder time effectively setting policy, making for an unstable economic situation.
To mitigate the effects of a dollar drain, central banks and governments will borrow money from offshore. A more drastic measure to curtail dollar drains is for countries to address the trade deficit itself. They could impose trade restrictions using tariffs and import controls. Governments could implement policy to make an investment in their own country more attractive, which will drain other countries' currencies, offsetting its own.
Dollar drain is related to the phenomenon of hot money flows, which happen when international capital, often denominated in dollars because the dollar is the defacto world reserve currency, flows into and out of an economy very quickly. The inflow can cause over-investment and speculation, and the outflow can cause economic collapse and deflation.
Before 1997, hot money inflows from developed economies in support of export-led growth strategies in Asian countries led to asset bubbles from Thailand to South Korea. The need to maintain dollar reserves in those economies created economic strain, and policymakers, first in Thailand and then in other Asian countries, removed their dollar pegs, resulting in dollar outflows. Disinvestment from these countries, including dollar drain, contributed to a financial crisis that decimated their economies.
Similarly, in China in 2015 and 2016, $300 billion of currency reserves flowed out of the country as hot money gave up on China and sought higher returns elsewhere. The result was a 33% drop in the value of stocks on the Shanghai Exchange and reverberations through the world economy.