Trade Deficit: Definition, Example, Effect on Stock Market

A trade deficit, also referred to as a condition that occurs when net exports are negative, is an economic condition that occurs when a country is importing more goods than it is exporting. The trade deficit is calculated by taking the value of goods being imported and subtracting it by the value of goods being exported.

If a country has a trade deficit, it imports (or buys) more goods and services from other countries than it exports (or sells) internationally. If a country exports more goods and services than it imports, the country has a balance of trade surplus.

A trade deficit can impact a stock market—albeit indirectly—since it can be a positive sign that a country is growing and needs more imports or a negative sign that a country is struggling to sell its goods internationally.

How Trade Deficits Work

A country's trade deficit or surplus is calculated by subtracting a country's imports from its exports. The balance of trade is denominated in the local currency of the country for which it is being calculated.

For example, let's say that the United Kingdom imported £800 billion (British pounds) worth of goods, while it exported only £750 billion. In this example, the trade deficit, or net exports, was £50 billion.

Measuring a country's net imports or net exports can be challenging. Investment flows in and out of the country and how much is being spent on imports are also important in determining a country's balance of payments. Balance of payments (BOP) is a net figure that shows how much money is leaving or coming into a country.

All types of trades and transactions are included in the BOP figure, including the trade deficit or surplus as well as investment flows from the private and public sectors. These investment and trade flows are accounted for in two different accounts called the current account and the financial account.

• The current account is used as a measure for all of the amounts involved in importing and exporting goods and services, any interest earned from foreign sources, and any money transfers between countries.
• The financial account is made up of the total changes in foreign and domestic property ownership.

The net amounts of these two accounts are then totaled to help form the balance of payments figure.

Why Trade Deficits Occur

A trade deficit can occur for a number of reasons, but typically a country has a deficit when it's unable to produce enough goods for its consumers and businesses.

For example, a country might have a limited amount of natural resources and as a result, needs to import raw materials such as lumber or oil to satisfy the country's demand for those commodities. Countries might also specialize in specific goods or industries.

For example, Canada exports seafood, oil, and lumber, while China exports electronics, clothing, footwear, and steel. A land-locked country would have no access to the sea and would need to import seafood to satisfy its consumer demand.

As a result, a trade deficit isn't necessarily a bad sign for an economy. On the contrary, a deficit could be a signal that a country’s consumers are wealthy enough to purchase more goods than their country produces.

Trade Deficits and Stock Markets

A sustained trade deficit could have adverse effects on a country and its markets. If a country has been importing more goods than exporting for a prolonged period, it could be going into debt (much like a household would).

Over time, investors could notice the decline in spending on domestically produced goods hurting domestic companies and their stock prices. As a result, investors could experience fewer investment opportunities domestically and begin to invest in more favorable opportunities in foreign stock markets. The result would be a lower stock market as investors sell domestically-held stocks and send capital flows overseas.

Conversely, trade deficits can occur when a country is expanding and growing. Emerging markets traditionally have had to run trade deficits as they build up their infrastructure, factories, and housing to support a growing economy. Once the industries have been established, an emerging market could import less and instead, domestically source its needs from its manufacturing sector.

Also, if a country is exporting more, those industries are selling more goods globally, which can lead to a rise in the stock market. However, a rise in exports is not mutually exclusive to changes in imports. In other words, countries could experience both an increase in exports and imports simultaneously as the country's economy grows—all while still running a trade deficit.

The imports could be needed as input goods for the production of the country's exports or sales overseas. A rise in exports contributes positively to economic growth because it would essentially be an increase in foreign sales for domestic companies. Higher economic growth could lead to a rise in consumer spending resulting in more purchases of imports. The growing economy would lead to a higher stock market. As a result, a trade deficit could coexist during times of economic expansion and a rising stock market.