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.