Balance of Trade, How to Calculate, and Favorable Versus Unfavorable
The Danger When Imports Exceed Imports
The balance of trade is the value of a country's exports minus its imports. It's the most significant component of the current account. That also makes it the biggest component of the balance of payments that measures all international transactions.
The trade balance is the easiest component to measure. All goods and many services must pass through the customs office.
How to Calculate It
A country's trade balance equals the value of its exports minus its imports.
The formula is X - M = TB, where:
X = Exports
M = Imports
TB = Trade Balance
Exports are goods or services made domestically and sold to a foreigner. That includes a pair of jeans you mail to a friend overseas. It could also be signage a corporate headquarter transfers to its foreign office. If the foreigner pays for it, then it's an export.
Imports are goods and services bought by a country's residents but made in a foreign country. It includes souvenirs purchased by tourists traveling abroad. 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.
When a country's exports are greater than its imports, it has a trade surplus. Most nations view that as a favorable trade balance. When exports are less than imports, it creates a trade deficit. Countries usually regard that as an unfavorable trade balance. But sometimes a favorable trade balance, or surplus, is not in the country's best interests. For example, an emerging market should import to invest in its infrastructure. It can run a deficit for a short period with this goal in mind.
Favorable Trade Balance
Most 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 products and receive more capital for their residents. It 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 doesn’t work for long. Soon other countries retaliate with their protectionist measures. A trade war will reduce international trade for all nations.
But 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 many of its imports are raw materials that it converts into finished goods and then exports. That gives it a competitive advantage in manufacturing and finance. It 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.
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 of consumer products. Their domestic businesses don't gain the experience needed to make value-added products. Their economies become dependent on global commodity prices. Such a strategy also depletes their natural resources in the long run.
Some countries are so opposed to trade deficits that they adopt mercantilism. This is an extreme form of economic nationalism that says remove the trade deficit at all costs. It advocates protectionist measures such as tariffs and import quotas. Although these measures can reduce the deficit, they also raise consumer prices. Worst of all, they trigger reactionary protectionism from the nation's trade partners. It lowers international trade, and economic growth, for everyone involved.
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. Treasurys 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. Chinese and Japanese citizens must save to provide for their old age since their governments don't have strong social services.
Difference Between Balance of Trade and Balance of Payments
The balance of trade is the most significant component of the balance of payments. The payments balance adds international investments plus net income made on those investments.
A country can run a trade deficit, but still have a surplus in its balance of payments. If the other components of the balance of payments are in a large enough surplus, it will offset a trade deficit. That can only occur if the financial account or capital account runs a huge surplus. For example, foreigners could invest heavily in a country's assets. They could buy real estate, own oil drilling operations, or invest in local businesses.
The capital account records assets that produce future income, such as a copyright. As a result, it would rarely run a surplus large enough to offset a trade deficit.
How the Trade Balance Fits Into the Balance of Payments
Balance of Payments
- Current Account
- Capital Account
- Financial Account