Balance of Trade

Much like we have the Gross Domestic Product calculation to understand how productive an economy is at any given time, the balance of trade calculation can be used to tell us how well an economy performs in the international markets.

You learned previously that GDP includes net exports, or the amount exported to another country minus the goods imported from another country. Now we need to look at the balance of trade, which is basically a focus around the “net exports” column.

What is Balance of Trade?

Balance of trade is the amount of exports for a particular country, minus the amount of imports. If a country exports more than it imports, then the balance of trade is said to be positive. The country is running a “trade surplus” in that it sells more to other countries than it buys from other countries.

The opposite is known as a trade deficit. Trade deficits happen when a country imports more stuff than it exports. Watching the balance of trade will allow us to get a top down view of the global economy.

We know the United States has a trade deficit with China. The United States imports more goods from China than it sells to China. Thus, China receives more dollars from US consumers than US businesses receive in Renminbi from Chinese buyers.

Good or Bad?

The balance of trade cannot directly tell us how an economy is performing based on trade deficits or surpluses. Trade deficits have, for a long time, been the mark of very successful economies.

Assume for just a moment that you are in the import and export business. You sell one product to one area, and buy another product to sell to another country. Let’s say you buy and sell candies and chocolates, and you live in the United States.

You purchase $100 worth of candies in the United States, which you export to…say, Germany. At the shores, $100 in imports are added to Germany’s current account. But you sell the products in Germany at retail for $120, netting a $20 profit.

You take that $120 and you then buy chocolates to bring back to sell in the United States. On the way back, $120 is added to the imports section of the United States’ current account, and you sell the products for $150, netting a $30 profit.

The diagram below shows your activity:

Germany imported $100 worth of product, but exported $120 in product, for a trade surplus of $20. The United States exported $100, but imported $120, for a trade deficit of $20.

The flaw in the balance of trade is that it forgets profit, and thus, trade deficits often come from country’s with profitable economies. In the round trip buying and selling action, you came away with $50 in profit, $20 of which was made in Germany, and $30 of which was made in the United States.

You actually removed money from the German economy, and brought it back to your home country. In this example, the US economy has “won” (if you can call it simple winning and losing, as consumers we all benefit from international trade) to the tune of $20, but that isn’t recorded on the balance of trade sheet.

Making it Actionable

After reading through this you might be thinking, “If trade deficits and surpluses don’t tell us directly how they affect currencies, then why do they matter?”

What matters isn’t the fact that they’re positive or negative. What matters is how they change over time.

If the United States has a $100 billion annual trade deficit with Europe, but then this grows to $150 billion, what can we draw from it? Well, we know that $50 billion more of dollars will have to be sold this year to buy Euros. That’s more demand for Euros, more supply for dollars, so the Euro should rise against the Dollar. We should buy EURUSD.

We can use this to confirm our suspicions about economies in general. If the European economy shows real GDP growth of 3% and the US economy has real GDP growth of 2%, then the European economy looks stronger—which should ultimately lead to a stronger Euro. Wham! We thought the GDP was telling us to buy Euros since they should rise in price against Dollars, and the balance of trade confirmed this to be the case!

Remember how we talked about central banks a few pages ago? In the next section, we’re going to bring back central banks to talk about how they can influence international trade.