A:

A country's balance of trade is defined by its net exports (exports minus imports) and is thus influenced by all the factors that affect international trade. These include factor endowments and productivity, trade policy, exchange rates, foreign currency reserves, inflation and demand. A crucial point to note is both goods and services are counted for exports and imports, as a result of which a nation has a balance of trade for goods (also known as the merchandise trade balance) and a balance of trade for services. A nation has a trade surplus if its exports are greater than its imports; if imports are greater than exports, the nation has a trade deficit.

Factor Endowments

Factor endowments include labor, land and capital. Labor describes the characteristics of the workforce. Land describes the natural resources available, such as timber or oil. Capital resources include infrastructure and production capacity. The Heckscher-Ohlin model of international trade emphasizes differences in these areas to explain trade patterns. For example, a country with an abundance of unskilled labor produces goods requiring relatively low-cost labor, while a country with abundant natural resources is likely to export them.

The productivity of those factors is also important. For example, suppose two countries have the same amount of labor and land endowments. However, one country has a skilled labor force and highly productive land resources, while the other has an unskilled labor force and relatively low-productivity resources. The skilled labor force can produce relatively more per person than the unskilled force, which in turn influences the types of work in which each can find a comparative advantage. The country with skilled labor might be better-suited to designing highly complex electronics, while the unskilled labor force might specialize in simple manufacturing. Similarly, the efficient use of natural resources can mean relatively more or less value extracted from a similar initial endowment.

Trade Policies

Barriers to trade also affect the balance of exports and imports for a given country. Policies that restrict imports or subsidize exports change the relative prices of those goods, making it more or less attractive to import or export. For example, agricultural subsidies might reduce the cost of agricultural activities, encouraging more production for export. Import quotas raise the relative prices of imported goods, which reduces demand. (For related reading, see: The Basics of Tariffs and Trade Barriers.)

Nations that are insular and have restrictive trade policies such as high import tariffs and duties may have larger trade deficits than countries with open trade policies, since they may be shut out of export markets because of these impediments to free trade.

There are also non-tariff barriers to trade. A lack of infrastructure is a notable one, as it can increase the relative cost of getting goods to market. This increases the price for those products and reduces a nation's competitiveness on the global market, which in turn reduces exports. Investment can work to reduce these barriers. For example, investments in infrastructure can increase a nation's capital base and reduce the price of getting goods to market.

Exchange Rates, Foreign Currency Reserves and Inflation

  • Exchange rates:  A domestic currency that has appreciated significantly may pose a challenge to the cost-competitiveness of exporters, who may find themselves priced out of export markets. This may pressure a nation’s trade balance. (For related reading, see: The Effects of Currency Fluctuations on the Economy.)
  • Foreign currency reserves: To compete effectively in extremely competitive international markets, a nation has to have access to imported machinery that enhances productivity, which may be difficult if forex reserves are inadequate.
  • Inflation: If inflation is running rampant in a country, the price to produce a unit of a product may be higher than the price in a lower-inflation country. This would affect exports, affecting the trade balance.

Demand

Demand for particular products or services is an important component of international trade. For example, the demand for oil affects the price and thus the trade balance of oil-exporting and oil-importing countries alike. If a small oil importer faces a falling oil price, its overall imports might fall. The oil exporter, on the other hand, might see its exports fall. Depending on the relative importance of a particular good for a country, such demand shifts can have an impact on the overall balance of trade.

Trade Balance as an Economic Indicator

The utility of trade balance data as an economic indicator depends on the nation. The biggest impact is generally seen in nations with limited foreign exchange reserves, where the release of trade data can trigger large swings in their currencies.

The trade data is usually the largest component of the current account, which is closely monitored by investors and market professionals for indications of the economy's health. The current account deficit as a percentage of gross domestic product (GDP), in particular, is tracked for signs that the deficit is becoming unmanageable and could be a precursor to a devaluation of the currency.

However, a temporary trade deficit may be viewed as a necessary evil, since it may suggest that the economy is growing strongly and needs imports to maintain the momentum.

The balance of trade is a key indicator of a nation’s health. In general, investors and market professionals appear more concerned with trade deficits than trade surpluses, since chronic deficits may be a precursor to a currency devaluation. (For related reading, see: The Pros and Cons of a Trade Deficit.)

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