Balance of Trade: Favorable vs Unfavorable

The Danger When Exports Don't Equal Imports

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All countries would prefer a trade balance with each other. Photo: Thomas Barwick/Getty Images

Definition: The balance of trade compares the value of a country's exports of goods and services against its imports. When exports are greater than imports, that's a trade surplus. Most nations view that as a favorable trade balance. The opposite, when the value of imports outweighs the value of exports, is a trade deficit. Countries usually regard that as an unfavorable trade balance. 

To determine whether a country truly has a favorable trade balance, you must answer three questions.

First, where is the country is in its business cycle? Second, how long has the deficit or surplus been ongoing? Third, what are the reasons behind it?

What Exactly Is the Balance of Trade?

The trade balance subtracts imports from exports. Imports are any goods and services that are made in a foreign country and bought by a country's residents. You may think of imports only as items shipped in from a foreign country. But imports also include souvenirs purchased by residents while traveling abroad. Citizens are importing the items in their suitcases. Services provided while traveling, such as transportation, hotels, and meals, are also imports. It doesn't matter whether the company that makes the good or service is a domestic or foreign company. If it was purchased or made in a foreign country, it's an import.

Exports are any goods or services sold by a native resident or business to a foreign one.

That includes a pair of jeans you mail to a friend overseas. It's also signage a corporate headquarters transfers to its foreign office. If the foreigner pays for it, then it's an export.

The balance of trade is the most significant component of the current account. That's what measures a country's net income earned on international assets.

It also includes all payments across borders. The trade balance is the easiest to measure. That's because all goods and many services must pass through the customs office.

The current account is itself part of a country's balance of payments, which measures all international transactions.

Favorable Trade Balance

Countries try to create trade policies that encourage a trade surplus. They consider a surplus a favorable trade balance because it's like making a profit as a country. Nations prefer to sell more and receive more capital for their residents. That translates into a higher standard of living. Their companies also gain a competitive advantage in expertise by producing all the exports. They hire more workers, reducing unemployment and generating more income.

To maintain this favorable trade balance, leaders often resort to trade protectionism. They protect domestic industries by levying tariffs, quotas or subsidies on imports. That usually works great until other countries retaliate with their protectionist measures.

Sometimes a trade deficit is the more favorable balance of trade. It depends on where the country is in its business cycle. For example, Hong Kong has a trade deficit.

But its imports are raw materials that it converts into finished goods and then exports. That gives it a competitive advantage in manufacturing and finance. That creates a higher standard of living. Canada's slight trade deficit is a result of its economic growth. Its residents enjoy a better lifestyle afforded by diverse imports.

Romania's former dictator, Nicolae Ceausescu, created a trade surplus that hurt his country. He used protectionism to bolster domestic industries. He also forced Romanians to save instead of spending on imports. That resulted in such a low standard of living that the people forced him out of office. (Source: "Canada's Economy," CIA World Factbook, "What's So Favorable About a Favorable Balance of Trade?" Hoover Institution, July 30, 1997.)

Unfavorable Trade Balance

Most of the time, trade deficits are an unfavorable balance of trade.

As a rule, countries with trade deficits export raw materials. They import a lot more consumer products. Their domestic businesses don't gain the experience needed to make the value-added products. Their economies become dependent on global commodity prices. Such a strategy also depletes their natural resources in the long run.

Once in a while, a trade surplus is an unfavorable trade balance. China and Japan have both become dependent on exports to drive economic growth. They must purchase significant amounts of U.S. Treasuries to keep the dollar's value high and the value of their currencies low. That's how they keep their exports competitively priced, and maintain their trade surplus. But this export-driven strategy means they rely on U.S. customers, and U.S. foreign policy. In addition, their domestic market is weak. Their people must save to provide for their old age, since the governments don't have strong social services. 

Balance of Trade vs. Balance of Payments

The balance of trade is one component of the balance of payments. The balance of payments also measures international investments and net income made on those investments.

A country can run a trade deficit, but still have a surplus in its balance of payments. How? Foreigners invest in the country's growth by loaning to businesses. They also buy government bonds and hire workers from that country. If the other components of the balance of payments are in a large enough surplus, a trade deficit can be entirely offset. 

How the Trade Balance Contributes to the Balance of Payments

What Is the Balance of Payments?

  1. Current Account
  2. Capital Account
  3. Financial Account