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What’s it: A trade surplus is when the value of a country’s exports exceeds its imports. In other words, the country reports a positive trade balance. Since international trade involves two different currencies for payment, a surplus also affects the domestic currency’s exchange rate.
The trade surplus leads to an exchange rate appreciation. Domestic currency becomes more valuable when converted into a partner country’s currency (for example, the US dollar). Exports encourage demand for domestic currency by foreigners to pay for the purchase of domestic goods. Meanwhile, domestic buyers will sell their domestic currency and convert it into the partner country’s currency to pay for imports. Therefore, a surplus leads to a higher demand for the domestic currency.
Various factors influence the trade surplus. The first is production costs. Lower costs allow for lower selling prices in international markets. The second is quality. Higher quality products also increase competitiveness.
Other factors that affect the trade surplus are the exchange rate, domestic economic growth, economic growth of trading partners, and inflation.
Calculating the Trade Surplus
The formula for calculating a trade surplus is simple. You subtract the total value of a country’s exports from its imports. If the result is positive, then the country records a surplus. Conversely, if the result is negative, the country runs a trade deficit.
- Trade balance = Total export value – Total import value
Factors Affecting the Trade Surplus
Several factors determine the size of the trade surplus. Three of them are:
- Economic growth
- Exchange rate
- Product competitiveness
Economic growth
During economic expansion, the economy is more prosperous. Income and employment prospects are improving. Strong demand for goods and services encourages businesses to increase production and recruit more workers.
If real GDP exceeds potential GDP (positive output gap), aggregate demand exceeds aggregate supply. Hence, the economy will import from abroad to supply the gap.
In such situations, the trade balance tends to be in deficit, assuming exports remain unchanged.
Meanwhile, more robust global growth, particularly in trading partner countries, is likely to point to a surplus, assuming constant imports. Strong economic growth in partner countries increases the demand for domestic products and increases exports.
Currency exchange rate
Currency depreciation makes domestic goods cheaper for foreigners. That should increase exports because goods are more competitive in the international market.
The impact of depreciation on exports depends on the elasticity of demand for domestic goods. If demand is elastic, depreciation should increase exports considerably, given that foreign buyers are relatively responsive to price changes.
On the other hand, depreciation makes foreign goods more expensive. That should reduce import demand.
As a result, depreciation should lead to a trade surplus, ceteris paribus.
The opposite effect applies when the domestic currency appreciates. Domestic goods become more expensive, weakening exports. Meanwhile, foreign goods are cheaper for domestic buyers, encouraging imports. As a result, the trade balance tends to be in deficit when the exchange rate appreciates.
Product competitiveness
The competitiveness of domestic products in international markets depends on quality and price. Improved product quality should increase demand and allow the company to offer a more premium price.
High-quality products, such as technology products, make the product relatively less sensitive to price changes because demand tends to be inelastic. Apart from that, their price is also higher. Thus, even though the quantity is relatively small, such products’ export value remains high because of the high price.
The second factor that affects competitiveness is the price. Low prices should increase demand, especially if the product tends to be elastic in demand.
Prices of domestic products in international markets depend on production costs and exchange rates. Lower product costs and depreciation favor lower prices on the international market, which should increase exports.
In aggregate terms, prices for domestic goods are reflected in the inflation rate. Thus, domestic goods are cheaper when domestic inflation is low compared to inflation in trading partner countries.
The Effects of Trade Surplus
The two main economic variables exposed to the trade surplus are real GDP and the exchange rate.
Impacts on economic growth and real GDP
Real GDP is the key indicator for measuring economic growth. When real GDP increases, the economy grows. Conversely, a decrease in real GDP leads to a contraction in the economy.
Real GDP measures the monetary value of the total product produced by the domestic economy. Some of the total products are consumed domestically, while others are exported. If exports increase, it encourages an increase in domestic production and increases real GDP.
Furthermore, some of the products consumed by domestic consumers are not domestic products, but foreign products. Therefore, the domestic economy must import them. Because they do not come from domestic production, imports reduce real GDP. Thus, economists say imports represent a leakage in the economy.
- GDP = Consumption + Government spending + Investment + (Exports – Imports)
When the trade balance is a surplus, it increases real GDP because exports exceed imports. That leads to higher economic growth. Strong demand for domestic goods encourages increased production and creates more jobs and income.
Impacts on the exchange rate
The trade surplus leads to an appreciation of the domestic currency. As I have previously stated, exports and imports involve not only transactions of goods and services but also currency as a means of payment.
When exports exceed imports, demand for the domestic currency is higher. That causes the domestic currency to appreciate.
However, the effect may be temporary. Appreciation ultimately makes the price of domestic goods more expensive for overseas buyers. On the other hand, the prices of imported goods are cheaper for domestic buyers. As a result, the trade surplus decreases.
Economists describe the relationship between the trade balance and the exchange rate using a curve called the J Curve.
Pros and Cons of a Trade Surplus
Trade deficits are not always bad. Likewise, the trade surplus is not always good. In this section, I will outline the advantages and disadvantages of the trade surplus.
Pros
The trade surplus is good because:
Encouraging economic growth. The surplus increases real GDP, encourages increased production, and creates more jobs and income for the domestic economy.
Increasing tax revenue. The increase in exports stimulates production activity and economic growth. The outlook for business profits and household income is improving, increasing the tax collection base.
It is possible to buy assets from other countries. The surplus creates additional money for the domestic economy, which can be used to buy assets in other countries, such as government bonds. For example, China uses a surplus from international trade to buy US Treasuries, which hold up to $1.1 trillion in 2019.
Improving sovereign rating. A surplus should lead to better creditworthiness because the country has the resources available to pay off debt. Likewise, a decrease in the trade deficit will improve the current account, which will lead to an increase in ratings or prospects, especially for low-rating countries.
Less vulnerable to speculative attacks. The trade surplus increases foreign exchange reserves. This increases the central bank’s credibility in intervening in the exchange rate market and countering speculative attacks.
Reducing the need for protectionism. A surplus could indicate a competitive domestic product in international markets. It reduces the need for protection, such as through government subsidies.
Cons
The trade surplus is bad because:
The current trade surplus may come at the expense of future growth. A surplus indicates a country has a very high domestic saving level, which is more than it can invest domestically. Therefore, the country invests additional funds abroad.
Weak domestic consumption. A trade surplus may arise when imports are lower rather than because exports are stronger. Low import demand indicates relatively weak domestic demand.
Relying on exports means being more vulnerable to external demand shocks. For example, the global recession makes it difficult for countries with trade surpluses to increase exports. Domestic consumption is relatively weak, so it cannot compensate for export shocks. That, in the end, can weigh on economic growth, as happened in Japan and Germany.
