Module 11

MODULE 11
BALANCE OF TRADE

5.1 INTRODUCTION
The balance of trade is the difference between a country’s money value of exports and
imports. Exports are domestically produced goods and services sold abroad; imports are the
purchase of foreign goods and services. The balance of trade is the value of a country's
exports minus its imports. It is the most significant component of the current account of a
country. The trade balance is the easiest component to measure all goods and many services
generated by a country. The balance of trade is the largest component of a country's balance
of payments (The balance of payments (BOP) is a statement of all transactions made between
entities in one country and the rest of the world over a defined period of time, such as a
quarter or a year.)Economists use the BOT to measure the relative strength of a country's
economy. The balance of trade is also referred to as the trade balance or the international
trade balance. A country that imports more goods and services than it exports in terms of
value has a trade deficit. Conversely, a country that exports more goods and services than it
imports has a trade surplus. The formula for calculating the BOT can be simplified as the
total value of imports minus the total value of exports. Many trade theories right from the
early times have taken into consideration the importance of the balance of trade. One such
theory that came out of the realisation of the balance of trade is the early theory of
Mercantilism, originating from Uruk. Mercantilism was one of the first attempts to develop
an economic theory as early as the sixteenth century. The presumption at that time was a
country’s wealth was measured in the amount of its gold and silver holdings. Therefore, in
order to increase these holdings, trade should be done by promoting exports and minimising
imports. The primary stance was the increase in the surplus of trade. This theory is regarded
as being selfish. This is so as it is based on the premise that one nation’s loss is another
nation’s gain. World history is indicative to the successful implementation and adaptation of
this theory as during that time, rulers and kings measured their power in accordance to the
factors such as the capture of states, increase in wealth and stronger armies. More gold and
silver along with other riches led to more economic power which is what this theory
proposes. Though ancient, traces of this can be seen in modern day economies such as that of
Japan, China and even Germany that favour exports and discourage imports by promoting
protectionist policies and increasing domestic subsidies. However, in the present day

scenario, a country, at least in theory, tends to balance trade or maintain a ratio which is
closest to this balance in order to be a strong player in the global market.

5.2 FEATURES OF BALANCE OF TRADE

The Balance of trade is present in the current account. The current account consists of
the balance of trade, net primary income or factor income (earnings on foreign investments
minus payments made to foreign investors) and net cash transfers, that have taken place over
a given period of time. The current account balance is one of two major measures of a
country's foreign trade (the other being the net capital outflow). A current account surplus
indicates that the value of a country's net foreign assets (i.e. assets less liabilities) grew over
the period in question, and a current account deficit indicates that it shrank. Both government
and private payments are included in the calculation.

It is called the current account because goods and services are generally consumed in the
current period. The current account consists of the balance of trade, net primary
income or factor income (earnings on foreign investments minus payments made to foreign
investors) and net cash transfers, that have taken place over a given period of time. The
current account balance is one of two major measures of a country's foreign trade (the other
being the net capital outflow). A current account surplus indicates that the value of a
country's net foreign assets (i.e. assets less liabilities) grew over the period in question, and a
current account deficit indicates that it shrank. Both government and private payments are
included in the calculation. Goods and services are generally consumed in the current period.
The balance of trade forms part of the current account, which includes other transactions such
as income from the net international investment position as well as international aid. If the
current account is in surplus, the country's net international asset position increases
correspondingly. Equally, a deficit decreases the net international asset position.

The trade balance is identical to the difference between a country's output and its domestic
demand (the difference between what goods a country produces and how many goods it buys
from abroad; this does not include money re-spent on foreign stock, nor does it factor in the
concept of importing goods to produce for the domestic market).

Measuring the balance of trade can be problematic because of problems with recording and
collecting data. Factors that can affect the balance of trade in a country are multiple. These

relate to the cost of production in the exporting economy vis-à-vis those in the importing
economy. Another factor that plays an important role is the cost and availability of raw
materials, and other intermediate goods and along with inputs. Currency exchange rate
movements and the cost of the currency directly effects the deficit or the surplus along with
the overall balance of trade. Multilateral, bilateral and unilateral taxes or restrictions on trade
act as important determinants as well. Non-tariff barriers such as environmental, health or
safety standards ae vital determinants and will be discussed in the next section. The
availability of adequate foreign exchange with which to pay for imports and the prices of
goods manufactured at home along with the rate of supply also contribute to this.

In addition, the trade balance is likely to differ across the business cycle. In export-led growth
(such as oil and early industrial goods), the balance of trade will shift towards exports during
an economic expansion. However, with domestic demand-led growth (as in the United States
and Australia) the trade balance will shift towards imports at the same stage in the business
cycle.

The monetary balance of trade is different from the physical balance of trade (which is
expressed in amount of raw materials, known also as Total Material Consumption).
Developed countries usually import a substantial amount of raw materials from developing
countries. Typically, these imported materials are transformed into finished products, and
might be exported after adding value. Financial trade balance statistics conceal material flow.
Most developed countries have a large physical trade deficit, because they consume rawer
materials than they produce. Many civil society organisations claim this imbalance is
predatory and campaign for ecological debt repayment. The factors of the balance of trade
have a direct effect thereof on its workings. Hence, in order to maintain the balance of trade,
these factors should be kept in check by a country.

5.3 THEORIES OF BALANCE OF TRADE
Many countries in early modern Europe adopted a policy of mercantilism, which theorized
that a trade surplus was beneficial to a country, among other elements such
as colonialism and trade barriers with other countries and their colonies. These practises were
regarded as selfish and the theory of mercantilism was said to be that which promoted selfish
trade between nations. The criticism of this theory mainly extended to the fact that it was a
theory which ought to enforce protectionism throughout the world. Gold and silver were
considered to be the nation’s wealth, completely disregarding other factors. This was known
as “Bullionism”. An example of a trade deficit can be said to be the country of Armenia
which has reached an all-time low in March 2009, due to the stagnancy of foreign trade and
border disputes. This in effect effects its trade with several other nations and put it’s in a
vulnerable position. Adam Smith was highly critical of this theory and advocated free trade.
He recognized that balance of trade was the way in which a country would benefit most from
international trade. The assumptions of mercantilism were therefore challenged by the
classical economic theory of the late 18th century, when philosophers and economists such as
Adam Smith argued that free trade is more beneficial than the protectionist tendencies of
mercantilism and that a country need not maintain an even exchange or, for that matter, build
a surplus in its balance of trade (or in its balance of payments).
John Maynard Keynes was much preoccupied with the question of balance in international
trade. He was the leader of the British delegation to the United Nations Monetary and
Financial Conference in 1944 that established the Bretton Woods system of international
currency management. He was the principal author of a proposal known as the Keynes Plan
which advocated an International Clearing Union. The two governing principles of the plan
were that the problem of settling outstanding balances should be solved by the generation of
foreign exchange, and that debtor and creditor should be treated almost alike as disturbers of
equilibrium. However, this plan was never implemented due to the American apprehension to
create a trading environment where the debtor and creditor were treated equally.

A complex regime was developed keeping in mind the benefits accruing from the various
systems of trade. This focused more on trade regulation than that on principles and therefore
focused to eliminate trade imbalances by the implementation of measures to regulate trade.

The main focus on this is the elimination of surplus and deficit issues. Trade surpluses lead to
weak global aggregate demand. Countries running surpluses exert a "negative externality" on
trading partners, and pose far more than those in deficit, which is a threat to global prosperity.

A nation with a surplus would need to get rid of it and in doing so, other nation’s deficits
would get cleared. Another ambit of this theory was the proposal of a bank of regulation
which would issue its own currency. This currency (bancor) could exchangeable with
national currencies at fixed rates of exchange and would become the unit of account between
nations, which means it would be used to measure a country's trade deficit or trade surplus.

Further, this theory stated that creditor nations may be just as responsible as debtor nations
for disequilibrium in exchanges and that both should be under an obligation to bring trade
back into a state of balance. Failure for them to do so could have serious consequences.

The development and need for the balance of trade was felt during the World Wars where dis
equilibrium and the misbalance of such trade cause a great deal of suffering and even
dissolution of economies. The Bretton Woods System was created with the mind-set to help
ensure uniformity in trade of some sort and to enable economies to move towards this
equilibrium. However, the emergence of the monetarist schools of thought took concentration
away from this line of thinking. The financial crisis that hit the world in the 2000’s led to the
re-emergence of this school of thought which promotes equilibrium.

Another theory that saw an emergence during the 20th century was proposed by the 19th
century economist and philosopher Frédéric Bastiat. The idea expressed in this theory is that
trade deficits actually were a manifestation of profit, rather than a loss.

Bastiat argued that the national trade deficit was an indicator of a successful economy, rather
than a failing one. He predicted that a successful, growing economy would result in greater
trade deficits, and an unsuccessful, shrinking economy would result in lower trade deficits.
This was later, in the 20th century, echoed by economist Milton Friedman. Friedman
presented his analysis of the balance of trade in Free to Choose, widely considered his most
significant popular work.

In the 1980s, Milton Friedman, a Nobel Memorial Prize-winning economist and a proponent
of monetarism, contended that some of the concerns of trade deficits are unfair criticisms in
an attempt to push macroeconomic policies favourable to exporting industries.

Friedman argued that trade deficits are not necessarily important, as high exports raise the
value of the currency, reducing aforementioned exports, and vice versa for imports, thus
naturally removing trade deficits not due to investment.

This position is a more refined version of the theorem first discovered by Hume. Hume
argued that England could not permanently gain from exports, because hoarding gold (i.e.,
currency) would make gold more plentiful in England; therefore, the prices of English goods
would rise, making them less attractive exports and making foreign goods more attractive
imports. In this way, countries' trade balances would balance out.

Therefore, it can be inferred that these theories have their merits and demerits in relation to
what they seek to infer. It is important to take the situation of the economy of a country into
consideration before application of these theories.

5.4 BALANCE OF PAYMENTS

The balance of payments, also known as balance of international payments of a country is the
record of all economic transactions between the residents of the country and the rest of the
world in a particular period of time. These transactions are varied and are of a different nature
i.e. are made by individuals, firms and government bodies. Thus the balance of payments
includes all external visible and non-visible transactions of a country. A country in order to
maintain its Balance of trade has to analyse the Balance of Payments.
The balance of payments provides detailed information concerning the demand and supply of
a country's currency. If a country imports more than it exports, then this means that the

quantity supplied of the country’s currency by the domestic market is likely to exceed the
quantity demanded in the foreign exchanging market. One can thus infer that the country in
question and their currency would be under pressure to depreciate against other currencies.
On the other hand, if a country exports more than it imports, then the currency of the country
would be likely to appreciate.

A country's balance of payments data may signal its potential as a business partner for the
rest of the world. If a country is grappling with a major balance of payments difficulty, it may
not be able to expand imports from the outside world. Instead, the country may be tempted to
impose measures to restrict imports and discourage capital outflows in order to improve the
balance of payments situation. On the other hand, a country with a significant balance of
payments surplus would be more likely to expand imports, offering marketing opportunities
for foreign enterprises, and less likely to impose foreign exchange restrictions.

Balance of payments data can be used to evaluate the performance of the country in
international economic competition. Suppose a country is experiencing trade deficits year
after year. This trade data may then signal that the country's domestic industries lack
international competitiveness.

There is a separate book to analyse the Balance of Payments made by a country in a
particular year called the Balance of Payments book. These transactions include payments for
the country's exports and imports of goods, services, financial capital, and financial transfers.
It is prepared in a single currency, typically the domestic currency for the country concerned.
The balance of payments accounts keeps a systematic record of all the economic transactions
of a country with all other countries in the given time period.

All the receipts from abroad are recorded as credit and all the payments to abroad are debits.
Since the accounts are maintained by double entry bookkeeping, they show the balance of
payments accounts are always balanced. Sources of funds for a nation, such as exports or the
receipts of loans and investments, are recorded as positive or surplus items. Uses of funds,
such as for imports or to invest in foreign countries, are recorded as negative or deficit items.

Therefore, in order to maintain equilibrium, the Balance of Payments should be at sum zero
indicating no surplus or deficit in the nation. The term balance of payments often refers to
this sum: a country's balance of payments is said to be in surplus by a specific amount if

sources of funds exceed uses of funds by that amount. This indicates a positive balance. A
deficit is said to occur if the former are less than the latter. This indicates a negative balance
of payments. A Balance of Payments surplus is accompanied by an accumulation of foreign
exchange reserves by the central bank. A deficit is accompanied by a dissemination of
foreign exchange reserves.

Under a fixed exchange rate system, the central bank accommodates those flows by buying
up any net inflow of funds into the country or by providing foreign currency funds to
the foreign exchange market to match any international outflow of funds, thus preventing the
funds flows from affecting the exchange rate between the country's currency and other
currencies.

Therefore, the balance of payments compliments a trading regime in which the balance of
trade exists. One of the most pertinent similarity is the fact that these regimes promote the
equilibrium status.

A country’s balance of payments (BOP) is vital for the following reasons:

Ø BOP of a country reveals its financial and economic status.
Ø BOP statement can be used as an indicator to determine whether the country’s

currency value is appreciating or depreciating.
Ø BOP statement helps the Government to decide on fiscal and trade policies.
Ø It provides important information to analyze and understand the economic dealings of

a country with other countries.

The differences between the two are expressed in the following table:

Balance of trade Balance of payments

The balance of trade includes only visible imports The balance of payments includes all
and exports, i.e. imports and exports of those visible and invisible items exported
merchandise. The difference between exports and from and imported into the country in
imports is called the balance of trade. If imports addition to exports and imports of

are greater than exports, it is sometimes called an merchandise.
unfavourable balance of trade. If exports exceed
imports, it is sometimes called a favourable
balance of trade.

The balance of payments includes all
The balance of trade includes revenues received or

revenue and capital items whether visible
paid on account of imports and exports of

or non-visible. The balance of trade thus
merchandise. It shows only revenue items.

forms a part of the balance of payments.

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