A balance of trade deficit exists for a country when the value of imports produced by the foreign sector and purchased by the domestic economy is greater than the value of exports produced by the domestic economy and purchased by the foreign sector. In other words, imports exceed exports and net exports are negative.
This is also commonly termed an unfavorable balance of trade because the excess of exports over imports creates a net outflow of monetary payments out of a country. This generates a decrease in aggregate income and associated measures, especially consumption, saving, investment, and tax revenue, which is rightfully considered to be "unfavorable" for the country.
A given country can have an "overall" balance of trade deficit in which imports from the foreign sector exceed exports to the foreign sector. One country can also said to have a balance of trade deficit with just one other country, in which imports from that country exceed exports to that country. For example, the United States might have an overall balance of trade surplus with the foreign sector, but a balance of trade deficit with China. An overall balance of trade deficit with the foreign sector does not necessarily mean a balance of trade deficit for every other country.
Balancing Net ExportsThe balance of trade is essentially another term for net exports. Net exports are the difference between exports to the foreign sector and imports from the foreign sector. Exports are goods and services produced by the foreign sector and purchased by members of the domestic economy. Imports are goods and services produced by the domestic economy and purchased by the foreign sector.
A balance of trade deficit then exists if imports exceed exports or net exports are negative. In contrast, a balance of trade surplus exists if exports exceed imports or net exports are positive. The balance of trade can also be "in balance" if exports equal imports and net exports are zero.
Why? How?A balance of trade deficit arises if imports exceed exports. Why does this happen? How might this occur?
The simple answer is that a country is exporting fewer goods and services to the foreign sector than it is importing from the foreign sector. A more complex answer requires a closer look at both exports and imports.
- Exports: A decrease in exports is just the thing that can create a balance of trade deficit. This might occur for reasons beyond control of the domestic economy, perhaps due to declining prosperity and stagnant economic activity in the foreign sector. Or an increase in exports might result from policy actions taken by the domestic economy specifically designed to decrease exports, including manipulation of currency exchange rates which can raise the effective price of exports.
- Imports: A balance of trade deficit can also result from an increase in imports. This might occur when domestic expenditures (especially consumption) is induced to increase by an expanding domestic economy. Or an increase in imports might result from policy actions specifically designed to boost imports, including a reduction in quotas or tariffs on imports or manipulation of currency exchange rates.
What It Means?Why exactly is a balance of trade deficit considered "unfavorable" or harmful to the domestic economy. A deficit in the balance of trade arises if the value of imports exceeds the value of exports. In terms of "payments," this indicates that the domestic economy is generating a net outflow of payments to the foreign sector. Fewer payments are coming in for the sale of exports than are going out for the purchase of imports.
The net outflow of payments means that the pool of aggregate revenue or income available to the domestic economy is less than it might be otherwise. That is, domestic producers, on net, have less revenue that can be either distributed to resource owners as national income or diverted to the government sector as taxes.
This lesser income and tax revenue then be reduces induced consumption expenditures, saving (which is the used for investment expenditures), and government purchases. Less revenue means less income which means less expenditures and less production. The result is lower living standards and a less prosperous economy. This is why a balance of trade deficit is also commonly termed an "unfavorable" balance of trade.
Ironically, however, a balance of trade deficit, which is deemed to be "bad" for a country might arise because the domestic economy is enjoying a serious business-cycle expansion. The growing economy and resulting boost in aggregate income induces an increase in domestic consumption expenditures, including the purchase of imports from the foreign sector.
This increase in imports can transform a balance of trade surplus into a balance of trade deficit, especially if the foreign sector remains unaffected and exports do not change. As such, while a balance of trade deficit is "unfavorable" for the domestic economy, it might actually be a sign that the domestic economy is doing well.
Unfavorable for All?That notion that a balance of trade deficit is "unfavorable" comes not only from the domestic view of the overall domestic economy, but also from the perspective of domestic producers. International trade is invariably good for some and bad for others. When the domestic economy trades with the foreign sector, domestic producers and domestic consumers do not benefit to the same degree.
Because imports exceed exports with a balance of trade deficit, domestic producers, on net, suffer whereas domestic consumers, on net, benefit. The end result is that a balance of trade deficit is "unfavorable" to domestic producers but often "favorable" to domestic consumers.
- Exports: First consider exports. Domestic producers that provide exports benefit from greater sales, more revenue, and higher profit. Resource owners engaged in the production of exports also gain from higher income. However, because domestic consumers are competing with the foreign sector, the prices of exports tend to rise and their availability tends to be less. Domestic consumers are often hurt by greater exports.
- Imports: On the import side, the story is largely reversed. Domestic producers competing with imports suffer from lower prices and fewer sales. They have less revenue and resource owners doing the production have less income. Domestic consumers, in contrast, benefit from lower prices and a greater selection of goods.
The "unfavorable" descriptor is commonly attached to a balance of trade deficit, in part, due to the aggregate impact on the domestic economy, but also in part because domestic producers tend to have more clout and their preferences tend to be more widely recognized than domestic consumers.
Balance of PaymentsThe balance of trade is actually one component of a more extensive set of international financial accounts termed the balance of payments. The balance of payments summarizes ALL payments between the domestic economy and the foreign sector. While payments for exports and imports constitute a major portion of these payments, they are not the only payments.
Other payments contained in the balance of payments include net transfers or gifts between the domestic economy and the foreign sector (primarily foreign aid between governments) and net investments in both physical capital and financial capital.
The overall balance of payments is necessarily in balance, with neither a surplus nor a deficit. A balance of trade deficit, as such, means that other payments are in an equal and opposite surplus. If a given country has a net outflow of payments on trade because imports exceed exports, then it has a corresponding net inflow of payments for transfers and investments.
Put another way, the foreign sector uses the extra revenue it receives from the net sales of exports for either foreign aid to domestic economy or more importantly to invest in the physical or financial capital of the domestic economy.
BALANCE OF TRADE DEFICIT, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2020. [Accessed: October 29, 2020].