The level of international trade a country engages in informs the state of its economy’s health. Reports of exports and imports are released regularly, and traders can utilize such reports to predict the trajectory of a country’s legal tender. This article will look at the balance of trade and its impact on currency prices.
Definition of the balance of trade (BoT)
Plainly put, BoT is the difference between the value of a country’s exports and that of its imports. It is measured in terms of whether a country managed to export more goods to foreign nations than it imported over a specified period. This figure provides insight into the state of the economy and the level of economic growth in the country.
When exports exceed imports, the balance of trade is said to be positive, which results in a trade surplus. This surplus means the country netted a profit from international trade, which can be used to develop the economy further.
When imports outweigh exports, the trade balance is negative, and the country is said to have a trade deficit. This basically means the government is spending more than it earns. It may be forced to implement new taxes or borrow from other countries or from the International Monetary Fund (IMF) to make up for the deficit.
Components of the balance of trade
The contributors to the balance of trade figures can be generally classified into goods and services. Goods refer to tangible objects that are either exported or imported by a country, such as a machinery, food, or medicine. Services refer to humans performing tasks for monetary gain. These may include entertainment, education, healthcare, and such.
Prices of these goods and services are dependent on factors such as the cost of raw materials, production costs, storage, and transport. The producer then adds their profit depending on the laws of demand and supply. This supply and demand are itself influenced by conditions such as inflation and taxes.
When foreign demand is high, especially from countries with stronger currencies, producers will want to export more goods and services so as to enjoy more profits. Similarly, a country with a bigger demand than supply will want to import the deficit from countries with weaker currencies, as this would lower the cost of said goods and services.
Calculating balance of trade
Based on the definition, the balance of trade is calculated using the formula:
Trade balance = Total exports – total imports.
In some countries such as France and the European Union, the balance of trade reports only include goods, not services. The French calculate the balance of trade for services separately, then combine the two figures in another report.
Effect of BoT on the economy
A positive balance of trade indicates that a country is utilizing its resources to create value. Positive BoT figures translate to an increased GDP, while a negative trade balance lowers the gross domestic product. However, a positive or negative trade balance is not sufficient to indicate a strengthening or weakening economy. To gauge this, you need to look at the context of the country’s state of economy.
Export driven and demand-driven growth strategies
When a country’s economy is in recession, the government will typically want to boost exports in a bid to increase its population’s disposable income. This is an export-driven strategy. Such a country will therefore be aiming for a trade surplus.
If a country is experiencing inflation, it will want to find cheaper imports so as to drive the local prices of goods and services down. This is called a demand-driven strategy. For such a country, a trade deficit would be positive for the economy, while a trade surplus would be detrimental.
Trade wars
A good instance of trade wars is the one that erupted between the US and China during the Trump administration. China is the world’s largest producer, while the US is the largest global consumer. This trade war saw Trump put limitations on Chinese imports, which ultimately drove their prices up. Considering that the US leads a demand-driven economy, this caused the country’s trade deficit to reduce, thereby devaluing the dollar.
Balance of trade as a fundamental indicator
Balance of trade is generally a lagging indicator, as it measures the trade activity of a country in hindsight. It can be used to gauge the state of an economy’s health and how close a country is to achieving its economic goals. What’s more, it is a huge contributor to GDP and, as such, can inform future government monetary policies.
Trading the balance of trade report
As we’ve established, the effect of the BoT report would depend on whether a country adopts the demand-driven strategy or an export-driven economic strategy. In a demand-driven economy such as that of the United States, a positive balance of trade would devalue the USD, while a trade deficit would raise its value against other foreign currencies. Similarly, an export-driven economy would benefit from a trade surplus, while a trade deficit would devalue its currency in the forex market.
Ultimately, the level of volatility caused by these figures depends on how much they deviate from analysts’ expectations. For instance, if the US trade deficit was significantly lower than expected, it could point to a possible economic recession. This may compel the Fed to raise interest rates so as to increase the USD’s purchasing power in foreign markets. This would make imports more lucrative, thus increasing the trade deficit.
Conclusion
Trade balance refers to the difference between the total exports coming out of a country and the total imports coming in. When exports exceed imports, it results in a positive trade balance which creates a surplus. When imports exceed exports, it creates a trade deficit. If a country’s economic strategy is demand-driven, a trade deficit will be bullish for its currency while a trade surplus will be bearish. However, if the country is export-driven, a trade surplus will be bullish for its currency, while a negative trade balance will be bearish for its currency.