Balance of Trade

What is Balance of Trade?

Balance of trade is a measure of a country's exports versus its imports. In simple terms, if a country sells more to other countries (exports) than it buys from them (imports), it has a positive or favorable, balance of trade. If it buys more than it sells, the balance of trade is negative or unfavorable.

Balance of Trade Definition

A formal definition of balance of trade is as follows:

A nation's trade balance is part of a larger macroeconomic measurement, the balance of payments.

The most important aspect of a nation's overall balance of payments is its balance of trade, whether a country has a trade deficit or a trade surplus.

The primary method for determining the balance of trade may be summed up as the difference between the entire value of a country's exports and the total value of its imports.

How to Calculate Balance of Trade?

Understanding how to calculate the balance of trade is crucial for assessing a nation's economic health. The balance of trade is calculated by subtracting the value of imports from the value of exports. In simple terms, the formula is:

\(\hbox{Balance of Trade}=\hbox{Total Exports}-\hbox{Total Imports}\)

Both exports and imports are considered over a specific period, typically a year. It's crucial to note that the value of goods and services includes not only the price of these items but also transportation, insurance, and any tariffs or taxes.

Consider an example: Country X exports goods worth $500 billion and imports goods worth $350 billion in a year. The balance of trade can be calculated using the formula mentioned above. So, the calculation would be:

\(\hbox{Balance of Trade}=\hbox{\$500 billion}-\hbox{\$350 billion}=\hbox{\$150 billion}\)

Hence, Country X has a positive balance of trade or a trade surplus of $150 billion.

However, if the result were negative, it would indicate a trade deficit. For instance, if Country Y exports goods worth $200 billion and imports goods worth $300 billion, the balance of trade would be:

\(\hbox{Balance of Trade}=\hbox{\$200 billion}-\hbox{\$300 billion}=\hbox{-\$100 billion}\)

In this case, Country Y has a negative balance of trade or a trade deficit of $100 billion. Understanding how to calculate the balance of trade provides insight into the economic condition of a country and its commercial relationships with other nations.

Types of Balance of Trade

The balance of trade can generally be classified into three types:

• Trade Surplus,
• Trade Deficit,
• and Balanced Trade.

Trade Surplus

A trade surplus occurs when the value of a country's exports exceeds the value of its imports. In other words, the country is selling more to other countries than it is buying from them. A trade surplus is often seen as a sign of economic success, as it indicates that the country is producing goods and services that are in high demand internationally.

Trade Deficit

Conversely, a trade deficit happens when a country's imports surpass its exports. This implies that the country is purchasing more from other countries than it's selling to them. While a trade deficit can be a sign of a strong consumer economy, it can also indicate that the country is not producing enough goods to meet domestic demand or that domestic goods are not competitive on the international market.

Balanced Trade

Balanced trade is the third type, and as the name suggests, it is a situation where a country's exports are equal to its imports. While balanced trade may sound ideal, it's rare in reality because trade flows are determined by a multitude of factors such as relative prices, exchange rates, and the economic policies of trading partners, which can shift and change. Regardless, it's a state that shows a perfect equilibrium in a country's trade activities.

Balance of Trade vs. Current Account

Although the balance of trade and current account are often used interchangeably, there are some differences between the balance of trade vs. the current account. The main difference between the balance of trade vs. the current account is that the balance of trade measures the difference in the value of exports and imports between countries. On the other hand, the current account measures the difference between total export and imports, foreign aid, and international investments.

Balance of trade is one of the biggest components of the current account. However, the current account is a broader measurement of international trade transactions between countries.

The current account balance of a country may either be in the form of a deficit or a surplus, depending on whether or not the nation's total revenues it receives from other countries are lower or higher than the total payments it has made to other nations.

Because the trade balance (the difference between exports and imports) is often the single most crucial factor in determining whether or not there is a surplus or deficit on the current account, the current account balance frequently has a cyclical tendency.

Import quantities often soar during robust economic progress, but if exports cannot expand at a comparable pace, the current account imbalance will worsen as a result. On the other hand, the current account deficit will decrease during a recession if imports go down while at the same time exports go up to countries that are doing well.

Balance of Trade Deficit

A trade deficit, or balance of trade deficit, is when a country imports more goods and services than it exports. Basically, it's when a country is buying more from the rest of the world than it's selling to it. This leads to more money flowing out of the country than coming in, creating a deficit in its balance of trade.

Trade deficits occur when a country cannot effectively generate its own goods because it lacks the knowledge and resources necessary to develop such goods and services or because it prefers to acquire commodities from another nation.

The effects of trade deficits include increased consumption and increased debt.

• Increased consumption. When a country has a balance of trade deficit, it indicates that it imports a greater quantity of products and services from other countries than it sends to other countries. In such a case, this country is capable of consuming beyond its production possibilities, which is the total amount a country can produce, given it uses all of its resources. That means that a country that experiences a trade deficit balance contributes to an overall improvement in the household level of life.
• Increased debt. It is undesirable to have a trade deficit since it requires additional financing, which might come in the form of borrowing money from the rest of the world, selling off assets, or delving into government reserves. If a country is running into a trade deficit, it has more money flowing out of the country to pay for the imports; however, to make up for that, that country has to incur debt. One example would be selling financial assets and using those funds to pay for imports.

Balance of Trade Deficit: United States Example

The United States is one of the most common examples of the balance of trade deficits.

Fig. 1 - U.S. Trade Deficits. Source: FRED St. Louis.¹

Figure 1 shows the U.S. balance of trade deficits between 2000-2021. The U.S. has been experiencing a deterioration in the balance of trade from the year 2000 up to 2006. The peak of the deficit improvement occurred shortly before 2010. After being relatively stable between 2011 and 2015, the trade deficit declined again in 2020 due to the effects of the pandemic.

The income growth experienced in the U.S. allowed its citizens to increase the purchases of goods and services from abroad, which is one of the main contributors to this enormous trade deficit. Another reason is the trade between U.S. and China. Due to China's ability to use cheap labor, making its products cheaper, the U.S. has been increasingly purchasing Chinese goods and services.

Balance of Trade and Exchange Rate

The balance of trade and the exchange rate are strongly influenced by one another. The balance of trade has an impact on the rates of currency exchange because of the way it affects the supply and demand for foreign currency.

When a nation's balance of trade does not balance out to zero — that is, when exports do not equal imports — there is significantly greater supply or demand for the country's currency, depending on the situation. On the global market, the price of that currency is affected as a result of this.

The values offered for currency exchange are relative to one another; the price of one currency is defined in terms of another currency.

The demand for currency, which is impacted by trade, is a significant factor affecting these relative values.

When a nation generates more revenue through exports than imports, there is a strong demand for the nation's products and, therefore, for the nation's currency. When there is a high level of need for a good or service, prices tend to go up, and the value of a currency tends to go up as well.

On the other hand, if a nation's imports exceed its exports, then there is a significantly lower demand for that nation's currency, and as a result, prices should fall.

Effects of Depreciation on the Trade Balance

A country's currency can either appreciate or depreciate, which will have effects on the trade balance.

This then starts to affect the overall balance of trade. When a country experiences a currency depreciation, it exports more and it imports relatively less. The result would be that the trade balance experiences an improvement. The improvement can either come from an increase in the surplus or an decrease in the deficit.

UK Trade Deficit

The UK trade deficit has been a significant issue in recent years. In 2022, the total annual trade in goods and services balance, excluding precious metals, widened by £85.3 billion to a deficit of £108.0 billion when compared with the previous year, according to a report by the Office for National Statistics (ONS).²

Total annual imports in the UK saw a considerable increase, rising by £218.2 billion (32.5%) to £889.2 billion in 2022 when compared with 2021. This value was also £186.5 billion (26.5%) higher than in 2018. Exports too saw a rise, but not as much as imports. Annual total exports increased by £132.9 billion (20.5%) to £781.2 billion in 2022 when compared with 2021, and were £109.0 billion (16.2%) higher than 2018.²

The surge in the UK's trade deficit can be attributed to a combination of factors. A significant contributor is the rising value of imports, a phenomenon driven largely by soaring energy prices due to Russia's invasion of Ukraine. As a net energy importer, the UK has seen gas prices reach record highs, a situation likely to further inflate the value of imports. Meanwhile, the country's exports have been struggling, potentially due to softening demand from key trading partners and ongoing Brexit trade frictions.³