What is Balance of Trade?
The Balance of Trade is the value of a country’s exports (“outflows”) minus the value of its imports (“inflows”).
Often used interchangeably with the term “trade balance”, the balance of trade is perceived to be favorable to a country’s economy if its export activities exceed that of its imports.
Balance of Trade Definition in Economics (“Trade Balance”)
The balance of trade, or trade balance, represents the difference between a country’s exports and imports.
- Exports → The goods and services sold to other foreign countries.
- Imports → The goods and services purchased by the country from foreign countries.
The trade balance can be determined by comparing the value of a country’s exports distributed to other countries relative to the value of its imports brought over from other countries.
- Trade Surplus → Exports > Imports (Positive Trade Balance)
- Trade Deficit → Exports < Imports (Negative Trade Balance)
Hypothetically, if we assume a marketplace where all participants are “rational” and sellers are driven by profit maximization above all else, the sellers in the market would seek to sell more of their goods and services than the amount purchased for consumption. Sellers can thus generate more sales along with higher profit margins from reduced spending.
But for sellers in an “irrational” market economy – in which maximizing profits is not the priority of market participants – close to all profits kept from their sales could be used to purchase goods and services from other sellers. In effect, the seller might be in a less favorable position because its spending exceeds its sales, resulting in reduced profit margins and less free cash flows (FCFs).
Balance of Trade Formula
The balance of trade formula subtracts the value of a country’s imports from the value of its exports.
For example, imagine a country’s exports in the past month were $200 million while its imports were $240 million.
The difference between the country’s exports and imports is -$40 million (a negative integer).
- Trade Balance = $200 million – $240 million = ($40 million)
Since the trade balance is negative, the country is categorized as having a trade deficit (or a $40 million deficit, to be more precise).
Trade Balance – Trade Deficit vs. Trade Surplus
The difference between a trade deficit and a trade surplus is briefly summarized below.
- Trade Surplus → The country’s balance of trade is positive, signifying that the value of the country’s net exports (“outflows”) exceeds the value of its imports purchased from other foreign countries (“inflows”).
- Trade Deficit → The country’s trade balance is negative, meaning that the value of the country’s net exports (“outflows”) is less than the value of the imports from other foreign countries (“inflows”).
Generally speaking, a trade surplus is viewed more positively than a trade deficit. The presence of a trade surplus is also frequently associated with increased economic output (i.e. productivity), lower unemployment rates, and more optimistic projections for near-term economic growth.
Countries can find themselves in a trade deficit for a multitude of reasons, but the most common causes are the following:
- Government Spending → Historically, a trade deficit has predominantly trailed increased government spending, which can result in the federal budget deficit expanding.
- Corporate Financing → The next factor contributing to a trade deficit is financing arrangements overseas, i.e. global corporate borrowings to raise capital. In particular, the U.S. has garnered a reputation for high corporate yields, with minimal country risk. The higher interest rates earned on debt securities issued by U.S. (or global) companies can make the U.S. more appealing for foreign investors to place their capital.
- Currency Exchange Rate → The third component to consider is the currency exchange rate. For example, a stronger U.S. dollar can cause foreign goods and services to become cheaper for consumers back in the U.S. (i.e. the import volume is likely to rise in such circumstances). Conversely, a strong U.S. dollar results in U.S. exports being more expensive for buyers in foreign countries.
- Economic Growth Rate → The final variable we’ll discuss here is the growth rate of the economy, which can be tracked using the leading economic indicators such as the gross domestic product (GDP). Simply put, a country with an economy growing more rapidly has a higher probability of being at a trade deficit, as consumers have more discretionary income to purchase more goods and services from countries abroad.
Favorable Balance of Trade
A favorable balance of trade describes the scenario in which a country’s exports exceed the value of its imports. Since we understand a country that imports more than exports is in a trade deficit while a country that exports more than it imports is in a trade surplus, the latter reflects the “favorable” trade balance that countries typically pursue.
- Favorable Trade Balance → If a country’s exports exceed its imports, it is said to have a favorable balance of trade, i.e. a trade surplus.
- Unfavorable Trade Balance → In contrast, if the country’s imports exceed its exports, a negative balance of trade exists, which is the concept of a trade deficit.
The net positive inflows from engaging in more exporting than importing can stimulate the economy and increase overall economic activity, especially if those conditions remain relatively constant for numerous years.
Nevertheless, measuring a country’s trade balance is not sufficient to gauge the true health and financial state of a country’s economy. While valuable insights can certainly be derived from the analysis, it is crucial to understand the comprehensive macro-perspective of the trade balance measurement.
In order to see the whole picture and come up with a defensible viewpoint on the conditions (and future outlook) of a country’s economy, an economist must also track other economic indicators that take a broader macroeconomic and microeconomic perspective.
Balance of Trade Calculator – Excel Model Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1. U.S. International Trade in Goods and Services Data (2022)
Suppose we’ve been tasked with calculating the trade balance of the U.S., specifically in the context of goods and services as part of international trade.
U.S. International Trade in Goods and Services, August 2022 (Source: U.S. Census Bureau and Bureau of Economic Analysis)
Step 2. Monthly U.S. Trade Balance Analysis
The far left column of the table lists the historical months from 2022 as of the present date, which ranges from January 2022 to August 2022.
The next two columns are “Exports” and “Imports”, and the final column on the far right is “Trade Balance”.
By subtracting the imports column from the exports column, we arrive at the trade balance for each month.
- Trade Balance = Exports – Imports
|U.S. International Trade|
|Month||Exports ($mm)||Imports ($mm)||Trade Balance ($mm)|
Step 3. U.S. Trade Deficit and YTD Trade Balance Calculation
For instance, the reported U.S. trade deficit in August 2022 was $67.4 billion, confirming our calculations are correct (or at least in the same ballpark as the actual economic data).
- Trade Balance = $258,918mm – $326,316mm = ($67,398mm)
The final step in our modeling exercise is to calculate the sum of the exports and imports columns and to subtract the two figures, resulting in a trade deficit of appropriately $674 billion.
U.S. Trade Deficit with China – Is the Deficit a Problem?
The act of evaluating the state of a country’s economy in itself is a rather complex topic, to say the least, as we can see in the case of the U.S.
The U.S. economy is widely considered to be the strongest in terms of gross domestic product (GDP) and total economic output. The GDP is an economic indicator used to measure the total value of finished goods and services created within a country’s borders.
However, the race between the U.S. and China has gradually become closer to the point that many expect China to overtake the U.S. in GDP within the next couple of years, especially considering the rapid pace of growth at which China was growing (i.e. the pre-pandemic slowdown that disrupted the global economy).
In spite of the strength of the U.S. economy, the U.S. has effectively been in a trade deficit for almost the entire time since the end of World War II (i.e. the 1970s).
The longstanding trade deficit of the U.S. economy reflects that the U.S. consumes more goods and services from abroad than it exports to other countries.
In fact, the U.S. set the record for the largest trade deficit in April 2022 by reporting a deficit of $112.7 billion.
U.S. Trade Deficit with China (Source: BEA.gov)
Unlike the U.S. and its trade deficit, China usually sits comfortably at a trade surplus by a substantial margin. But a trade surplus is not necessarily a sign that a country’s economy is healthy, as demonstrated by the economy of Japan.
- U.S. Trade Deficit is a Problem → The U.S. economy is considered in grave trouble to some economists considering its outstanding national debt balance and the adverse long-term effects of a trade deficit. But the degree of risk and potential monetary losses associated with the trade deficit is where economists disagree.
- U.S. Trade Deficit is NOT a Problem → On the opposite side of the argument, certain economists stand by the notion that a trade deficit signifies a robust and stable economy with even more growth in store. From the viewpoint of these economists, the existing trade deficit is not itself a problem for the U.S. economy. According to their research findings (and theories), a large trade deficit can often result from a healthy economy because consumers increase spending and import more goods and services.
The truth is likely somewhere in the middle of the trade deficit debate. While a trade deficit is not inherently positive or negative, the market forces at play and the economic context in terms of the country’s prevailing conditions are what determine the severity of any negative consequences of a long-term trade deficit.