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.

Key Takeaways

  • Balance of trade is defined as a nation's net exports, or its exports minus imports.
  • When exports exceed imports, the nation has a trade surplus, and when imports exceed exports, the nation has a trade deficit.
  • Factor endowments, such as labor, affect the balance of trade by what is produced and by whom.
  • International trade is largely affected by the demand for a nation's goods and services.

Factor Endowments

Factor endowments include labor, land and capital. Labor describes characteristics of a country's 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 the characteristics of a country's labor, land and capital to explain trade patterns. For example, a country with abundant unskilled labor produces goods requiring relatively low-cost labor, while a country abundant natural in resources is likely to export them.

The productivity of these factors is also essential. Suppose two countries have an equal amount of labor and land endowments. Yet one country has a skilled labor force and highly productive land resources, while the other has unskilled labor and relatively low-productivity resources.

The skilled labor 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 labor might design complex electronics, while the unskilled labor force might specialize in basic manufacturing.

Likewise, 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 impact a country's balance of exports and imports. Policies that restrict imports or subsidize exports impact the relative prices of those goods, making it more or less attractive to import or export. For example, agricultural subsidies might reduce farming costs, encouraging more production for export. Import quotas raise prices for imported goods, which reduces demand.

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.

There are also non-tariff barriers to trade. A lack of infrastructure can increase the cost of getting goods to market. This increases the price for those products and reduces a nation's global competitiveness, 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 raises the cost of exported goods and can leave exporters priced out of global markets. This may pressure a nation's trade balance.
  • Foreign currency reserves: To compete effectively in international markets, a nation must 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 impact exports, thus affecting the trade balance.

Demand

Demand for particular products or services is an essential component of international trade. For example, the demand for oil impacts the price and 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 most significant 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 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 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.