Balance of Trade - How to Calculate, Types and Importance

It is June 2020, the Indian government is considering actions to be taken against the Chinese incursion in Aksai Chin. A member of the cabinet suggests economic retaliation. On hearing this, everyone goes silent. The implication is obvious, India cannot hurt China without hurting itself. Why? Because India needs China’s trade.

 

The above situation illustrates a concept known as Balance of Trade. Balance of Trade is defined as the difference between the exports and the imports of a country with respect to either another country or the global economy at large.

 

The concept of Balance of trade also gives rise to two more terms - Trade Deficit and Trade Surplus. Before understanding what each of those terms mean, it is important to understand the mathematical representation of Balance of Trade. 

 

 

How is Balance of Trade Calculated?

 

In simple terms, the

 

Balance of Trade = Exports - Imports

 

Here, Export refers to any commodity that is locally produced and sold on the world market or to another country. The best example of this process is the Business Process Outsourcing(BPO) industry. 

 

Indian Call centers are famous world over with American companies often outsourcing customer support to India. With over 350,000 Call center workers in the country, it remains to be a big source of income. The BPO sector is one of the biggest contributors to India’s exports.

 

Imports refer to foreign commodities brought into the Indian market and sold here. An example of an import would be the oil and petroleum industry. India as a country is not rich in oil therefore to meet the demand for oil and petrol, India imports large amounts from Iraq and Saudi Arabia’s Aramco. 

 

These processes involve paying other countries for products therefore money goes out of the economy. In calculating balance of trade, imports are deducted as they require money to flow out of an economy.

 

With the above background, it remains to be seen that a trade deficit (where imports outweigh exports) and a trade surplus (where exports outweigh imports) are the two possible scenarios.

 

Types of Balance of Trade

 

Based on the numerical value of Balance of Trade, it is considered favourable or unfavourable. The reasoning behind the same is that a positive Trade Balance suggests that a country exports more. Export driven economies are known for economic growth and generation of employment. 

 

Exports also enable a country to compete in an international market thus increasing competition and efficiency. Thus brings out the first type of Balance of Trade - Favourable Balance of Trade.

 

On the other hand, a negative Trade Balance is considered unfavourable. Since a negative trade balance suggests more imports than exports, the net value of commodities goes negative with money flowing out of an economy. 

 

This presents a problem for most countries as in the long term, this involves incurring debts and foreign loans. Case in point the United States. The United States is the world’s largest debt economy with one of the largest trade deficits in the world. 

 

With over a trillion dollars in debt, it remains to be seen that the country will be subject to a day of reckoning. All of this is due to an unfavourable trade balance that results in a debt driven economy. 

 

The one redeeming factor in the US’s case is that the US treasury can declare interest rates as per their requirement, however, a minimum interest rate would be required to maintain investor confidence. 

 

How the United States deals with their debt problem will establish a precedent in the effects of Trade Deficit and the importance of Balance of Trade.

 

 

Importance of Balance of Trade

 

Trade deficit refers to a situation where Balance of trade is negative, i.e where imports are greater than exports. Trade Surplus refers to a situation where Balance of trade is positive, i.e where exports are greater than imports. But why is this important?

 

Balance of Trade has widespread contemporary relevance in the modern world. It remains the best indicator of a nation’s dependence on other nations and the extent of foreign trade. Balance of Trade is important for the following reasons:

 

1. Balance of Payments

 

Balance of Trade is important in calculating the balance of Payments of countries. Balance of Payments refers to the ledger of an economy. How much it owes to other countries and how much it is owed. 

 

In modern economies, loans and financial aid are not the only factors that are calculated as a part of Balance of Payments. Along with loans and debts through treasury bonds, the trade deficit or surplus can also be included in Balance of Payments. 

 

As a method to reduce foreign debt, economists use trade surpluses to show that although money isn't being directly paid back, it is reaching the people through trade.

 

(Speaking of Trade, check out our blogs on Types of Trading)

 

 

2. International Trade

 

Nations with higher trade deficits tend to have more free import and export policies. These nations tend towards capitalism and the free market to allow for international trade to flow more easily. 

 

The exception being during crises where countries restrict trade in the interest of domestic stability. A notable example would be India’s export of onions. During India’s Onion crisis in 2013, the Indian government banned exports of onions so that prices do not soar even higher. 

 

The onion, often considered the poor man’s vegetable, nearly brought the Indian government to its knees. India, which has a trade surplus in agricultural goods, had to control its exports due to crises. 

 

In other sectors such as industry or medical equipment, movement of products are being made so much more free. Thus, high trade deficits usually indicate lower tariffs and lesser barriers to trade. 

 

 

3. Effect on GDP

 

Balance of trade is an important factor playing into the calculation of the Gross Domestic Product of a country. As part of GDP calculations, exports are added and imports are subtracted from the total. Therefore, greater the trade surplus, greater the GDP of a country. 

 

The reasoning behind this is that GDP is the measure of the total value produced in a country. While imports require money to flow out of the country, exports bring money into the country. 

 

However, this is not always the case. During times of recession, countries often have to import to maintain supply chains and ensure their citizens have the necessary resources. 

 

Additionally, in attempts to revive business, import tariffs are often reduced to increase competition thus reviving the economic efficiency of a country.

 

 

4. Foreign Exchange

 

Balance of Trade is also an important determinant of a country's foreign exchange reserves. Through government taxes, the Central Bank can impose export tariffs and thereby increase a nation’s foreign exchange reserves. 

 

These Reserves are vital during times of crises and in obtaining international loans. For countries to be able to obtain loans from International Institutions. During the 1991 balance of payments crisis. 

 

The country was only able to secure loans from the IMF and World Bank after mortgaging gold reserves, and in the modern economic world with gold’s dwindling supply, it is foreign exchange that presents the ideal internationally accepted collateral for any and all international lending programs.
 

 

With all the above factors  considered, Balance of trade remains an important measure of an economy’s health. It can act as an early warning system for debt and forex crises in the future and can give national planners or governments an accurate indicator of how to plan or prepare with regards to International Trade. 

 

The role of a Trade Deficit or surplus can also give countries weaponry in international relations help countries negotiate a better position on the international political spectrum. 

 

One of the fundamental driving factors in poverty alleviation is for third world nations to achieve political power through economic recognition and Balance of Trade plays a very important role in achieving the above.

 

(Now that we mentioned Trade, you can also sneak a peek at our blog on Types of Trade Barriers)

 

 

Conclusion

 

As a consumer, a positive balance of trade can negatively affect prices causing them to go up as the local market is not subject to international trade while as a producer it provides additional market security and reduces business risk. 

 

Governments must take cognizance of negative Trade Balances and impose the necessary Trade Barriers. Through protection of local enterprises and encouraging policies of local production, both the Trade Balance and local employment see positive results. 

 

Ultimately, Trade Balance is an example of the Trickle Down effect with its implications being seen only at the Macroeconomic level. It is only policy changes and systemic reform that can affect it. Ignoring Trade Balance is like ignoring a slowly mutating cancer. Without early detection or diagnosis, it will kill the economy and all of its people.