Contents
What’s it: Trade balance is the difference between the country’s export value and its import over a certain period. When exports’ value exceeds imports, the country runs a positive trade balance (trade surplus). Meanwhile, if the value of imports exceeds exports, the country experiences a negative trade balance (trade deficit).
International trade involves not only the flow of goods and services but also different currencies for payment. Therefore, in addition to affecting domestic economic growth, the trade balance position also affects the exchange rate.
Furthermore, in the balance of payments, the trade balance number is under the current account category and usually accounts for a significant portion.
The difference between the trade balance and the balance of payments
The trade balance is part of the balance of payments. Specifically, it is under the current account section. Meanwhile, as the name suggests, the balance of payments summarizes all payment transactions between a country and the world.
The balance of payment comprises two components: current accounts and capital accounts. The current account consists mainly of the trade balance and factor income payments. Meanwhile, the main component of the capital account is investment (direct investment and portfolio investment).
The sum of current and capital transactions must equal zero. So, if a country’s trade balance is a deficit, it will be offset by investment inflows (capital account surplus). The deficit suggests that the country has to borrow from foreigners to cover it, leading to an inflow of foreign capital. The opposite condition applies when the country experiences a trade surplus.
Calculating the trade balance
To calculate the trade balance, you only need an arithmetic equation. You can calculate this by subtracting the export value from the import value. The following is the trade balance formula:
- Trade balance = Value of exports – Value of imports
Two terms related to the trade balance:
- A positive trade balance (or trade surplus), that is, if the value of exports exceeds the value of imports
- Negative trade balance (or trade deficit), which is if the value of imports exceeds the value of exports
The effects of the trade balance on the economy
The trade balance affects other economic variables. This section focuses on its impact on economic growth and the exchange rate because trade directly affects domestic production activity and demand for the domestic currency.
Trade balance effect on economic growth
Exports stimulate domestic economic growth, which is measured by real GDP growth over time. Real GDP represents the monetary value of products produced by the domestic economy, measured at constant prices. If exports increase, it increases the demand for domestic products and encourages firms to increase output. Increased production creates more jobs and income in the domestic economy.
Conversely, imports reduce real GDP. When imports increase, they stimulate production, job creation, and income increases in partner countries, not in the domestic economy. Therefore, economists refer to imports as leakages in an economy.
Next, let’s link exports, imports, and GDP. Under the expenditure approach, economists formulate GDP as follows:
- GDP = Consumption + Investment + Government spending + (Exports – Imports)
From this formula, you can see that exports are positively related to GDP, while imports negatively impact. When a country reports an increased trade surplus, it pushes GDP up and stimulates economic growth.
Trade balance effect on the exchange rate
As I said earlier, exports and imports involve not only goods and services but also different currencies as a means of payment.
An increase in exports increases the domestic currency demand, leading to an appreciation of the domestic currency. To pay for purchased products, overseas buyers must convert their currency into the domestic currency. Therefore, when exports increase, it encourages higher demand for the domestic currency. Appreciation indicates that the purchasing power of the domestic currency against the currencies of partner countries is strengthening.
Conversely, an increase in imports increases the demand for partner countries’ currencies, leading to the depreciation of the domestic currency. The increase in imports encourages domestic buyers to sell their currencies and exchange them with partner countries’ currencies to pay for imports. The increase in demand for the partner country’s currency increases its price (purchasing power) against the domestic currency, leading to the depreciation of the domestic exchange rate. Meanwhile, partner countries see their currencies appreciate.
Overall, when a country experiences a trade deficit, the exchange rate tends to depreciate. Conversely, a trade surplus will lead to currency appreciation.
However, the effect may be temporary because the price mechanism will have the opposite effect.
For example, depreciation makes the prices of domestic products cheaper for overseas buyers, which should increase exports. On the other hand, imports have decreased because foreign products have become more expensive, which will lead to appreciation.
The opposite effect applies when the domestic currency appreciates.
Economists describe the relationship between the trade balance and the exchange rate in a graph called the J Curve.
Trade surplus or deficit, whichever is better
A trade deficit or surplus is not always bad or good. It depends on economic fundamentals and the reasons behind them, such as trade policy decisions, their positive or negative duration, economic growth, and the size of trade imbalances.
If it runs a trade surplus, a country finances its trading partners’ trade deficit by lending to them or buying their assets (such as sovereign bonds). Conversely, when it records a trade deficit, the country has to borrow from foreigners or sell assets (capital inflows).
Some economists like trade surpluses because they promote economic growth and stimulate job creation and income. The deficit produces the opposite effect.
However, a trade deficit may indicate the economy is growing. Import demand is so high because aggregate demand exceeds aggregate supply (inflationary gap). In other words, domestic demand exceeds what can be supplied from domestic production. That drives high demand for imported products, which may lead to a trade deficit.
Likewise, a trade surplus occurs because the country relies on export growth to boost economic growth. Domestic consumption is low and underdeveloped. Such a situation is dangerous if the world economy goes into recession, which could shake its exports and economic growth. Domestic consumption cannot grow at a rate that can compensate for the decline in exports.
Factors affecting the trade balance
Five factors affect the trade balance, including:
- Economic growth and income, both domestic and global
- Product competitiveness (price and quality)
- Exchange rate
- Trade barriers
Economic growth and income
Strong economic growth increases the standard of living and income of a country’s population. Businesses expand, creating more jobs and income in the economy.
Such conditions will lead to increased import demand. Households increase demand for consumer goods from abroad. Likewise, to support production, businesses will also increase the demand for capital goods and raw materials.
Meanwhile, exports depend on economic conditions in partner countries or the global economy. A growing global economy increases the demand for domestic goods, stimulating increased exports.
Exchange rate
When a country’s exchange rate appreciates, its purchasing power against foreign currencies strengthens. This makes foreign goods relatively cheaper, thus stimulating import demand. Conversely, for overseas buyers, appreciation makes domestic goods more expensive, reducing exports.
Meanwhile, if the exchange rate depreciates, domestic goods become cheaper for foreigners, leading to increased exports. Conversely, imported goods become more expensive for domestic buyers, reducing their demand for imports.
The impact of changes in exchange rates on the trade balance also depends on two other factors, namely:
Economists typically use real exchange rate indicators to see how they affect the trade balance rather than the nominal exchange rate. The nominal exchange rate is adjusted for domestic inflation and inflation in partner countries. Because inflation reflects the average level of prices for goods and services in an economy, it can also affect export and import product demand.
Meanwhile, demand elasticity tells you how responsive domestic and overseas buyers are when the price of goods changes (for example, due to depreciation). If they are responsive (elastic demand), a decrease in price will stimulate high demand.
Let’s say that foreign buyers are relatively responsive to changes in the prices of domestic goods. Depreciation makes domestic goods cheaper, stimulating them to increase demand substantially. For example, if prices fall by 5%, their demand for domestic goods will increase by more than 5%. Conversely, when the domestic currency appreciates, their demand will decrease considerably.
Product competitiveness
The competitiveness of a product in the international market depends on the selling price and its quality. One of the key factors for selling prices is the cost structure.
Low input prices allow domestic businesses to have a low-cost structure. They can sell goods at low prices, making them more competitive in the international market. This is one reason why China is the world’s biggest net exporter.
Meanwhile, quality depends on product differentiation. The differentiated product provides producers with market power. An example is Germany’s high-tech capital goods. Even though it is more expensive, the market is still interested in it. It makes Germany one of the countries with the largest trade surplus in the world.
Trade protection
Trade protection can take the form of tariffs or non-tariff barriers. Examples of non-tariff barriers are import licenses, export licenses, import quotas, subsidies, voluntary export restrictions, local content requirements, embargoes, currency devaluations, and dumping.
Impacts of protection on the trade balance depend on the significance and type of trade barriers.
