Dollar drain is a term that describes the trade deficit a country has against the United States when imports from the US exceeds the exports to it.
As the US currency is the US dollar, a trade deficit essentially means that country would be spending more US dollars than earning them.
Thus, a dollar drain.
To pay for the deficit, the importing nation needs to buy US dollars from the foreign exchange with the local currency.
The implication is that if the US dollar is appreciating against the importing country’s currency, it would become more and more expensive to service the trade deficit.
If this relationship is maintained for an extended period, the importing country’s currency would only continue to depreciate in value against the greenback.
This is a reason why some nations choose to implement strategies such as buying gold to hedge against the translation risk.
However, the most common strategy central banks use manage the exchange rate between the US dollar and a country’s currency is by keeping a foreign currency reserve, or to keep the local currency trading within a trading band.
Singapore for example, is know to use a complex trading band approach to manage foreign exchange risks against the US dollar.
When exchange fluctuations threaten to breakthrough the trading band, the central bank would buy or sell dollars to keep the exchange rate within the range of the band.
While a dollar drain is mostly used to describe the trade relationship between a country and the US, at the macro level, it can also be used by companies at a micro level.
This can be applicable when a trading company does a lot of business with US companies in imports and exports.
When the company imports more products from the US than it exports, then it would also be experiencing a dollar drain.
The opposite of a trade deficit is a trade surplus.
