Balance of Trade (BOT):

BOT and BOP

Balance of Trade (BOT):

Balance of trade is the net exports (NX) of a country.

Net exports are the difference between a country's merchandise exports (X) minus its imports (M).

BOT includes import and export of physical and tangible goods.

Three situations are possible:
1)

NX = X-M = 200 - 100 (billion dollars) = 100 billion dollars.

This is called a trade surplus.

So if X > M, we have a trade surplus.

2)

NX = X-M = 200 - 400 (billion dollars) = -200 billion dollars.

This is called a trade deficit.

So if X < M, we have a trade deficit.

3)

NX = X-M = 200 - 200 (billion dollars) = zero dollars.

This is called a trade balance.

So if X = M, we have balanced trade.

Factors affecting BOT:

1) Exchange rates:

2) Trade barriers:

3) Economic conditions at home:

Economic impact of balance of trade:

Y= C + I + G + (X-M) or

National income = Consumption + Investment + Government expenditure + (Exports - Imports)

All of these variables have a positive impact on Y (GDP), except imports, which affects national income negatively.

But in GDP accounting, exports and imports are not accounted for independently, but their net effect called net exports (X-M) affects the GDP.

If X > M, (X-M) is positive, it's a trade surplus and it positively affects GDP.

If X < M, (X-M) is negative, it's a trade deficit and it negatively affects GDP.

If X = M, (X-M) is zero, it is balanced trade, and there is no effect on the GDP.

Balance of payments (BOP):

It is a record of all transactions between one country and the rest of the world.

It includes goods, services, financial assets, real assets, transfer payments etc.

It is measured per year.

It is a flow variable.

It is recorded on a double entry bookkeeping methodology.

The outflow of payments made to the rest of the world is recorded in the debit account.

The inflow of receipts from the rest of the world is recorded in the credit account.

The debit side has to match the credit side and hence it is called the Balance of payments (BOP).

The major entities in the BOP are:
1) Balance of trade:

This is the trade in physical goods.

Exports are credited in the BOP account since it is an inflow of money.

Imports are debited in the BOP since it is an outflow of money.

If exports >imports = trade surplus

If exports< imports = trade deficit

If exports = imports then we have balanced trade.

The USA has had a trade surplus up to 1975.

Ever since then, a trade deficit.

2) Balance on goods and services:

The balance of trade is balanced on goods (physical entities).

Then there is trade in services which are intangible as insurance, banking, tourism, consulting etc.

If the USA gets paid for any of these then it enters as a credit in the BOP.

If the USA pays for any of these then it enters as a debit in the BOP.

 

BOT Surplus or deficit good or bad

BOT: Surplus or deficit: good or bad:

This is the balance of trade (BOT) or also called net exports.

BOT is the difference between a country's exports (X) and imports (M)

If X is greater than M: Net exports are positive and it's a BOT surplus

If X=M: Net exports are zero and it's called balanced trade

If X is less than M: Net exports are negative and it's a BOT deficit

Another term used in this context is "trade balance."

It is the difference between a country's output and her consumption or domestic demand (DD.)

If output > DD, the gap is exported and it's a trade surplus since X is greater than M

If output =DD, X=M and we have balanced trade

If output < DD, the gap is imported and it's a trade deficit since X is less than M

BOT is influenced by factors affecting a country's exports and imports.

Broadly they are:
1)

Value of the local currency, in our example US dollars.

If the dollar is strong, M is greater than X and we will have a trade deficit.

If the dollar is weak, M is less than X, we will have a trade surplus
2)

Cost of production at home and abroad.

If the cost of production at home is greater than the cost of producing the same good abroad, imports will exceed exports.

This is generally true for the USA vis-a-vis China.

Reversely, if the cost of production at home is less than the cost of producing the same good abroad, exports will exceed imports.

This is generally true for China vis-a-vis USA.

3)

The stage of the business cycle a country is in.

For example generally during the expansionary phase of the business cycle, income is high and so consumption is also possibly high, leading to greater imports and reduced exports.

But, the reverse causality is also possible.

During the expansionary phase the local currency (the US dollar) may become stronger and appreciate, reducing exports and increasing imports.

The final net outcome between the two is difficult to predict.

The reverse causation logic can be applied in case of a country in the downswing of a business cycle.

 

BOP Surplus or deficit Good or bad

If a country's export (X) is less than its imports (M), there is a trade deficit.

That deficit is counterbalanced by earnings from foreign investments and / or foreign loans.

Thus overall a country's BOP is always in balance.

But individual items can be in surplus or deficit, as discussed below.

BOP constitutes the current account (CUA) and the capital account (CAA).

The current account is the sum of the country's:

a) Balance of trade (X-M)

b) Factor earnings which is the difference between a country’s earnings from foreign investment and her payments to foreign investors.

c) Cash transfer amongst countries which includes present (current) transactions only, not future income and payment streams

CAA is the net change in foreign assets.

It is the loans and investments done in foreign countries and the payments from foreign countries.

Like the CUA, it includes present (current) transactions only, not future income and payment streams

BOP= CUA-CAA (+ or -) balancing item.

The balancing items are statistical / accounting errors which are allowed because of the complexity of the items and the volume of revenues in the CUA and the CAA.

By standard double entry accounting methods, CUA-CAA =0, but it is not always exact.

So some accounting leeway is allowed in terms of the balancing item.

In the CUA we have exports (accounted in credit) and imports (accounted in debit) double entry accounting system.

Net outcome:

M>X: trade deficit

M=X: balanced trade

M<:X trade surplus

Factor earnings go in credit, while factor payments go in debit entry.

Reserve account includes the country’s central bank (The Federal Reserve in the USA) reserves of foreign exchange.

The International Monetary Fund (IMF) definition of BOP:

BOP=CUA-CAA-FA(= + or -) BI

Financial accounts are transactions in capital accounts.

Causes of BOP imbalances:

The USA has a large deficit which could be because of:

a) It could be caused by factors affecting the current account

b) High exchange rate or appreciating dollar, resulting in high imports from the rest of the world, and low exports to the rest of the world.

c) Government running large deficits

d) Safe haven currency.

This is true for the USA, where other countries save / invest in US dollar assets and so money flows into the USA.

This lowers interest rates and raises consumption.

This increases the deficit.

The US dollar is the reserve currency for the world.

Even today, 65% of global reserves are in US dollars, and 25% in EURO.

A BOP crisis is a bad thing and should be avoided.

It happens when a country has taken huge loans for consumption which is not self sustaining, meaning they do not give returns.

Once the investor countries become concerned about the loanee country being able to pay back its loans, they may start to call back their loans.

This is the genesis of a BOP crisis.

Once a crisis of confidence atmosphere is created, the country’s foreign exchange value drops, exacerbating the crisis.

Cure:

Changing the country’s exchange rate which is very difficult (nay impossible) under the floating exchange rate system.

The logic is say if the dollar depreciates (on its own) then US exports will increase while her imports will decrease, improving her BOT account.

But the flip side of this is that a depreciating dollar may cause concern in financial markets, resulting in outflow of funds, causing the capital account to deteriorate.

So it is a balancing act.