Impact of Trade Deficits and Surpluses on Investors
World trade has been credited with everything from driving global economic growth to ensuring a high level of world peace. Economists at the World Trade Organization (“WTO”) estimate that cutting trade barriers in agriculture, manufacturing, and services by just one-third would boost the world economy by $613 billion, while tighter economic integration has made it much more costly for countries to declare war on each other.
In this article, we’ll take a look at how economists measure world trade on a country-by-country basis, comparing a country’s exports to its imports.
Trade Deficits & Surpluses Defined
The world’s countries can generally be divided into net exporting and net importing countries, based on their balance of payments or net exports. This figure is calculated by adding the total net value of imported and exported goods, foreign interest and money transfers – known as the current account – to the total change in foreign and domestic property ownership – known as the financial account – to come up with a comprehensive figure.
These dynamics lead to what is known as trade deficits and surpluses:
- Trade Deficits: Trade deficits occur when a country imports more products than it exports. For example, if the U.S. were to import $800 billion worth of goods and export only $200 billion worth of goods, there would be a $600 billion trade deficit.
- Trade Surplus: Trade surpluses occur when a country exports more products than it imports. For example, if China were to export $1 trillion worth of goods and import only $200 billion worth of goods, it would have an $800 billion trade surplus.
It’s important to keep in mind that trade deficits and surpluses may require some investigation below the surface, too. For example, the Economist points out that the Apple iPad is imported from China and the $275 production cost counts as a trade deficit for the U.S. However, the vast majority of the profits actually flow into Apple Inc., a U.S. company, while the value added from work in China amounts to just $10 of the $275 production cost.
Trade deficits and surpluses have an immediate impact on several important economic indicators, including important things like the gross domestic product (“GDP”). However, these figures must be considered within the context of a country’s overall size. For example, the U.S. may have a large trade deficit, but since most of its goods and services are produced and consumed domestically, this trade deficit doesn’t have a major impact on its overall GDP.
Often, investors should pay the closest attention to the current account as a percentage of GDP, since it shows the current account number relative to overall economic output. Trade balances should also be balanced by an equal dollar amount of foreign direct investment to maintain global purchasing power. If the current account deficit rises as a percentage of GDP and FDI doesn’t balance out the different, a country could be headed for trouble.
Trade surpluses can be extremely important to watch in countries that rely on exports to drive economic growth, too. For example, oil exporting countries may rely on trade surpluses to fund public programs or sovereign wealth funds. Decreases in oil prices could lead to narrower trade surpluses and greater difficulties with public finances. And in some cases, these scenarios could lead to higher political risk in the affected regions.
The Bottom Line
Trade deficits and surpluses play a key role in global markets - particularly in export-driven economies and emerging markets. Investors should be mindful of the risks associated with both persistent trade deficits and narrowing trade surpluses, which can reduce global purchasing power and lead to higher political risks, respectively. It's also important to keep in mind that trade deficits and surpluses don't matter as much in developed countries where it accounts for a small fraction of GDP.