What Is Balance Of Trade?

As a major indicator of economic growth potential and an important part of the GDP, the BoT figures are carefully monitored by governments and central banks to adjust their policies.


Balance of Trade

In the simplest terms, Balance of Trade (BoT) is the value of a country’s trade – total exports minus total imports – for a given period of time. The BoT is also referred to as the trade balance, the international trade balance, commercial balance, or the net exports. The data on import and export of the Indian economy is published by the Ministry of Commerce on a monthly basis.

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BoT is used to measure the country’s economic and political stability by referring to the level of foreign investment in the country.

While importing and exporting goods, there are two situations that may arise: 

BoT deficit: This happens when the value of imports surpasses the total value of exports within a year. A trade deficit means that the country is spending more than it earns in the global arena. Consequently, the government might be forced to implement new taxes or borrow from other countries or international money organisations like International Money Fund (IMF) to cover for the budget shortage.

BoT surplus: This happens when the value of exports is more than the value of imports of the country in a year. A trade surplus means that the country made profits from international trade. The government can use this extra budget to increase either local investments to enhance the standard of living, or foreign investments to create new income sources for the country.

BoT is considered a crucial factor of a country’s current account. While measuring international transactions, the BoT accounts for the biggest factor of the Balance of Payment. Therefore, BoT is used to measure the country’s economic
and political stability by referring to the level of foreign investment in the country.

Types of Balance of Trade

Favourable: A favourable BoT is a situation when a country’s exports are more than its imports. Countries with a favourable BoT are in a much better position to enhance the standard of living of its population as they are able to generate more income with the surplus trade.

Unfavourable: An unfavourable BoT results due to increase in imports than exports. This creates a trade deficit. As such, countries with trade deficits export raw materials and import a large number of consumer products. Due to this, the domestic business is not able to add value to their products due to lack of skills. With time, these economies become dependent on global commodity prices.

Formula

The following equation is used to calculate the BoT of a country: 

Value of Exports-Value of Imports = Balance of Trade

Where:

Value of Exports is the value of goods and services that are sold to buyers in other countries.

Value of Imports is the value of goods and services that are bought from sellers in other countries.

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Countries with a favourable BoT are in a much better position to enhance the standard of living of its population as they are able to generate more income with the surplus trade.

Components 

There are 3 components of the BoT. These indicators are mainly used to compute the trade output and the results can either be trade deficit or surplus. Analysing the BoT gives an idea of the cash outflow and inflow of the country:

  • Current account

The current account is used to record the receipts and payments of all exported and imported goods that include raw material supplies and manufactured goods.

  • Financial account

The financial account is important to evaluate the change of domestic ownership of foreign assets and foreign ownership of domestic assets. When the foreign ownership is more compared to domestic ownership, it results in a deficit in the financial account.Therefore, analysing and understanding the changes in this account allows determining whether the country is selling or acquiring more assets.

  • Capital account

The account measures financial transactions between countries is known as capital account. It includes the purchase and sale of assets, properties and flow of taxes. The deficit or surplus in the capital account is managed through finance in the current account.

Factors affecting BoT

Cost of production

The cost of production includes (land, labour, capital). For example, a country with abundant unskilled labour (cheap labour) produces low-cost goods, hence more competitive leading to higher exports. Similarly, a country with abundant natural resources is likely to export them. The productivity of these factors is also essential. Suppose two countries have an equal amount of labour and land endowments. Yet one country has a skilled labour force and highly productive land resources, while the other has unskilled labour and relatively low-productivity resources. The skilled labour force can produce relatively more per person than the unskilled force, which in turn impacts the areas in which each can find a comparative advantage. The country with skilled labour might design complex electronics, while the unskilled labour force might specialise in basic manufacturing. The cost and accessibility of raw equipment, transitional goods and other inputs also play a major role. 

Exchange rate movements

Exchange rate has an effect on the trade surplus (or deficit), which in turn affects the exchange rate, and so on. In general, however, a weaker domestic currency stimulates exports and makes imports more expensive. Conversely, a strong domestic currency hampers exports and makes imports cheaper.

Inflation

Inflation in the country will increase the internal cost of production and increase the price. Naturally, the product will become less competitive in the international market and demand will come down. This would impact exports, thus affecting the trade balance.

Aggregate demand/income 

Changes in national incomes in both foreign or domestic countries have an important effect on exports. If national income in foreign countries rise, foreign residents would demand greater amounts of goods and services. This will lead to increase in exports of other countries and rise in imports of the country with higher income/demand.

Trade policies

Trade barriers/restrictions impact a country’s exports and imports and hence the BoT. Countries impose trade barriers, such as tariffs and imports quotas, in order to protect their domestic industries by making them less attractive (expensive). For instance, a high custom duty on a good will make it more expensive and thus less attractive to import. Nations that restrict trade through high import tariffs and
duties may run larger trade deficits than countries with open trade policies. This is because impediments to free trade may shut them out of export markets.

How Balance of Trade affects the economy?

BoT is used to measure the relative strength of a country’s economy. It reveals whether the country is generating extra resources beyond its local capacity to create value. It also shows how a country competes in the global marketplace besides determining the health of the economy and its relationship with the rest of the world.

As a major indicator of economic growth potential and an important part of the Gross Domestic Product (GDP), the BoT figures are carefully monitored by governments and central banks to adjust their policies. A trade surplus usually increases the GDP, while a trade deficit weakens it. BoT is also a major component of a country’s current account, and in some cases a growing current account deficit is an indication that the trade deficit in the country is becoming unmanageable, leading to a devaluation of the nation’s currency.

Interpretation of BoT for an economy: Is unfavourable BoT always bad?

Although most countries aim for a positive trade balance, surplus or deficit does not necessarily indicate economic strength or weakness. The BoT figures should be interpreted in the context of the country’s current economic conditions, countries involved, economic policies, size of the trade imbalance and business cycles. In short, the BoT figure alone does not provide much of an indication regarding how well an economy is doing. Economists generally agree that neither trade surpluses or trade deficits are inherently ‘bad’ or ‘good’ for the economy. Let us understand how.

In times of economic recession, the government can adopt an expansionary economic policy to stimulate the economy with an export-led growth strategy.The goal is to bring foreign resources home by increasing the volume of foreign sales. Thus, a trade surplus would be considered as an achievement, and a trade deficit would be a shortcoming of the policy. However, if the economy is already expanding, a contractionary economic policy might be used to keep the inflation rates under control with demand-led growth.

Importing more foreign goods and services can encourage price competition in the domestic economy. As a result, a trade deficit would be the healthy natural consequence, while a trade surplus would signify the inefficacy of import activities.

How is India’s Balance of Trade?

India, being a developing and emerging market economy, typically runs a deficit on the current account to meet the growing demand, rising national incomes and to supplement domestic savings with foreign savings to fund higher investment. However, for the first time in near two decades, India registered a merchandise trade surplus (last recorded in March 2002) of $0.79 billion in June 2020 from a deficit of $3.1 billion in May 2020 as exports rebounded from coronavirus-triggered disruptions at a faster pace than imports. India last posted a merchandise trade surplus of $10 million in January 2002.

India’s decline in imports outweighed that in exports – leading to a smaller trade deficit of US$ 57.5 billion in April-December, 2020-21.

Naina Sood
Naina Sood
Naina was former staff at Dutch Uncles, she writes on business-life-cycle, funding, small businesses and start-ups.

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