Breaking Down The Balance Of Trade

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The balance of trade is the difference between a nation's exports and its imports. A crucial point to note is that 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. The net or overall figure forms the balance of trade or "trade balance," a major contributor to a country's economic well-being. 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.

Trade Data – Census Basis and BOP Basis
While data on a nation's exports and imports of physical goods can be collated from customs documents such as export declarations and import manifests, this is not possible for trade in intangible services. The latter is therefore compiled based on the flow of funds, the foundation on which balance of payments (BOP) trade statistics are based. Therefore, data on merchandise trade is available based on both custom-based trade statistics and BOP, while data on services is only available on a BOP basis.

For example, in the U.S., statistics on exports and imports are compiled by the Commerce Department's Bureau of Economic Analysis (BEA) and released in a monthly report. The BEA collates information on exports from exporters' electronic export information (EEI) that have been submitted to the U.S. Automated Export System (AES). Exporters submit this export information to the U.S. Census and also to U.S. Customs and Border Protection. Similarly, import data is compiled from documents collected by the U.S. Customs and Border Protection pertaining to goods that have arrived in the U.S. from foreign countries. The BEA adjusts the goods total on a census basis to bring the data in line with the concepts used to prepare national and international accounts. The BOP-basis data derived in this manner enables goods trade numbers to be summed with services trade figures to arrive at a more accurate picture of overall U.S. trade, goods and services.

Distinguishing Between a Service Export and Import
Statistics for trade in services are derived from the BEA's estimates of service transactions between foreign countries and the U.S., based on periodic surveys and partial information from monthly reports. The BEA provides export and import data on services in a number of categories – travel, passenger fares, royalties and license fees, transfers under U.S. military sales contracts (only for exports), and direct defense expenditures (only for imports).

While the distinction between an export and import of a physical good is readily apparent, it is not as clear for a service. Here, the flow of funds determines whether a service transaction qualifies as an export or an import, depending on whether it is a debit transaction that results in a payment or outflow of funds, or a credit transaction that results in a receipt or inflow of funds.

So, for instance, fares received by U.S. carriers from foreign residents for travel between the U.S. and foreign countries, or between two points overseas, would show up on the export side of the trade balance for services. Likewise, fares paid by U.S. residents to foreign carriers would show up on the import side of the trade balance for services.

Breaking Down the Balance of Trade Numbers
Consider the U.S. trade balance figures for June 2013. The U.S. reported a trade deficit of $34.2 billion, the smallest deficit since October 2009 and well below the $45 billion deficit expected on average by economists.

Here's how the numbers stacked up for that month:
The merchandise trade (balance of trade for goods) deficit was $53.16 billion, as exports of $134.26 billion were exceeded by imports of $187.42 billion. These figures are BOP-based. The numbers on a census basis are slightly different, with exports of $133.31 billion and imports of $185.10 billion, for a trade deficit of $51.79 billion. The balance of trade for services was a surplus of $18.94 billion (exports of $56.91 billion less imports of $37.97 billion). The overall balance of trade was therefore -$53.16 billion + $18.94 billion = -$34.22 billion. Total exports of goods and services (BOP-based) amounted to $191.17 billion ($134.26 + $56.91), while total imports were $225.39 billion ($187.42 + $37.97). Subtracting total exports of goods and services from total imports gives the same trade deficit number of $34.22 billion. Capital goods ($46.22 billion) and industrial supplies ($42.32 billion) were the biggest export categories for goods in the month. On the goods import side, industrial supplies and materials ($54.6 billion, of which petroleum accounted for $22 billion) and capital goods ($45.58 billion) were the biggest categories. In services, the biggest categories among exports were "other private services" ($25.87 billion) and travel ($11.27 billion). The former category includes financial services, insurance services, business and professional services, and so on. Among service imports, these two categories were the biggest as well (other private services totaled $17.26 billion and travel $7.15 billion). Factors That Affect Trade Balance
Numerous factors affect a country's trade balance. These include:
Trade policies: Nations that are insular and have restrictive trade policies such as high import tariffs and duties may have larger trade deficits than countries that have open trade policies, since they may be shut out of export markets because of these impediments to free trade. Exchange rates: A domestic currency that has appreciated significantly may pose a challenge to the cost-competitiveness of exporters, who may find themselves priced out of export markets. This may pressure a nation's trade balance. Foreign currency reserves: To compete effectively in extremely competitive international markets, a nation has to 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 affect exports, affecting the trade balance. Use Trade Balance As An Economic Indicator
The utility of trade balance data as an economic indicator depends on the nation. The biggest 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 GDP, in particular, is tracked for signs that 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 that the economy is growing strongly and needs imports to maintain the growth momentum.

Trade data is also parsed to see which trading partners are contributing to the overall surplus or deficit. In June 2013, for example, the U.S. had a trade deficit of $26.6 billion with China, bringing its year-to-date deficit with the Asian giant to $147.7 billion. In contrast, the trade deficit with Canada – the biggest trade partner of the U.S., accounting for 16.8% of total trade in the first half of 2013 – was only $1.6 billion, for a YTD deficit of $15.5 billion. China's enormous trade surplus with the U.S. may lead to renewed calls for the nation to revalue its yuan, which critics opine is being held artificially low to stimulate exports.

U.S. trade data occasionally affects the greenback, which in turn has an impact on commodity prices because of the negative correlation between the two (stronger dollar causes weaker commodity prices and vice versa). These moves often result in volatility in Canada's TSX Composite index, which has a heavy weighting in commodities.

In general, market watchers appear more concerned with trade deficits than trade surpluses. This may be because chronic deficits often trigger a steep currency devaluation, leading to severe repercussions for the local economy as the higher interest rates that are used to prop up the currency take their toll. In summer of 2013, the currencies of India and Indonesia slumped 14% in just over two months as investors focused on nations with large trade and current account deficits. While India's foreign currency reserves grew in leaps and bounds after the economic reforms of the 1990s, rising gold imports in 2013 led to widening trade deficits, causing the Indian government to take measures to restrict gold imports.

The Bottom Line
The balance of trade is a key indicator of a nation's health. Trade balance data is available on a census / customs basis and BOP-basis for goods, and only on a BOP-basis for services. 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.