DEFINITION of 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.
BREAKING DOWN Dollar Drain
A dollar drain is, in essence, a trade deficit. For example, if Canada has exports $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.
Dollar Drain, Devaluation and Economic Policy
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.
The risk of a dollar drain is the ineffectiveness when implementing monetary policy. To handle monetary policy, a central bank requires a substantial amount of currency reserves. 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 borrowing 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 through tariffs and import controls. Governments could implement policy to make investment in its own country more attractive which will drain other countries currencies, offsetting its own.