Current Account, Balance of Trade
This lesson will cover the following
- What is the Balance of Payments?
- Current Account
- Capital Account
- Balance of Trade and its significance
In the previous articles in Chapter 2 “Fundamental analysis” we explained some of the major fundamental indicators which measure the strength of an economy and its segments, logically referred to as market movers. But as we know, there is no economy that functions on its own. Some countries, typically the developing nations, are rich on natural resources and rely on exporting them, while others have a vast industrial sector, typically the developed countries, but almost no raw materials to fuel their production. This means that imports and exports will play a major role for the economic expansion of those two types of countries, making the Balance of Trade a significant determinant of the economys current state.
The Balance of Trade is the largest component of a countrys current account, which respectively is one one of the two primary components of the Balance of Payments, the other being the capital account.
Balance of Payments
The Balance of Payments is a statement which reflects all monetary transactions between a country and the rest of the world. It encompasses all payments for the countrys exports and imports of goods, financial capital, financial transfers and services. All these transactions are classified in two accounts – the current account and the capital account.
Upon including all of the BoP components, the account should match zero without leaving any deficit or surplus. If for example a country is importing more goods than it is exporting and has a trade deficit, then the shortfall should be offset by another entry, such as using central bank reserves, accumulating debt etc.
The balance of payments is impacted by governments economic policies and reflects their results. Some countries adopt policies which aim to attract foreign capital in a particular sector, while others artificially depress their local currency in order to gain a competitive edge on the international markets so they can boost their exports and build up their currency reserves.
The current account can be most generally described as the difference between a nations savings and its investments. It is the sum of the balance of trade, net current transfers (cash transfers) and net income from abroad (earnings from investments made abroad plus money sent by individuals working abroad to their families back home, also known as remittances, minus payments made to foreign investors).
Note that investments stand in the capital account of the balance of payments but income from investments is recorded in the current account.
A current account surplus increases a countrys net foreign assets by the respective amount, while a deficit does the opposite. A country with a current account surplus is said to be a net lender to the rest of the world, while the reverse puts it in the position of a net borrower.
A net lender is consuming less than it is producing, which means it is saving and those savings are being invested abroad, thus creating foreign assets.
A net borrower is absorbing more than it is producing, which can only mean other countries are lending it their savings, thus creating foreign liabilities, or the country is using up its foreign currency reserves.
Changes in the US current account are reported four times per year. The indicator is released in the last month of each quarter and reflects data from the previous quarter, e.g. the second-quarter current account balance is released in September. This is a gauge causing medium volatility but can have a sizable effect on the US dollar, especially if it exceeds expectations. A better-than-expected reading should be taken as bullish for the greenback, while a worse-than-projected value is presumed as bearish.
Generally, a current account deficit is considered as negative for the exchange rate of the local currency, while the surplus is typically a good thing. There are however some peculiarities, which we will explain when we discuss the trade balance as it makes up most of the current account.
The capital account is the second major component of the balance of payments and reflects the change in asset ownership of a nation. It is the net result of private and public international investments going in and out of a country.
A surplus in the capital account means that more money is flowing into the country, suggesting an increase in foreign ownership of domestic assets, while a deficit means that money is flowing out of the country, indicating that the nation is increasing its ownership in foreign assets.
The capital account is basically the difference between the change in foreign ownership of domestic assets minus the change in domestic ownership of foreign assets. If we break those down, there are four elements:
– Foreign direct investments
– Portfolio investments
– Other investments
– Reserve account
Balance of Trade
The Balance of Trade, or commercial balance, is the difference between the monetary value of a country’s exports and imports for a period of time, calculated in the local currency. It is also identical to to the difference between an economys output and domestic demand, i.e. what the countrys domestic production amounts to and how much it consumes. When exports exceed imports, or there is a positive balance, we have a trade surplus, while the contrary position is called a trade deficit.
There are several factors which affect a countrys trade balance.
– exchange rate movements
– the cost of raw materials and other inputs
– prices of domestically produced goods
– the difference between the cost of domestic production and the cost in the importing country
– taxes and restrictions on trade
– differences in safety, health and environmental standards
The balance of trade is one of the most misunderstood indicators since its interpretation is not as straightforward as some other major market movers.
Since a trade surplus indicates the country is exporting more goods than it is importing, this means that there will be heightened demand for the local currency by foreign buyers, who will need to acquire a certain amount of it in order to conduct payments and purchase those goods. For example, if the US economy was running a trade surplus, this would mean increased demand for the US dollar as there are more foreigners buying the US dollar in order to purchase US goods than Americans who are selling the greenback in order to purchase goods from, lets say China.
Logically, a trade deficit implies that there is a greater number of people who are selling the local currency, in our case the US dollar, in order to purchase foreign goods than the people who are buying the currency so that they can purchase domestic goods, in our case US goods.
An example of what influence changes in the US trade balance could have on the US dollar is provided in the following screenshot. It has captured the release of the US trade numbers on September 4.
Source: MetaTrader 4 by MetaQuotes Software Corp.
The Department of Commerce reported at 12:30 GMT that the US trade deficit widened to $39.147 billion in July, undeperforming expectations for a less increase to $38.600 billion. Additionally, the preceding months reading received an upward revision to $34.543 billion from initially estimated at $32.224 billion.
Have in mind that a trade deficit is not always a bad thing and it depends on the business cycle of the economy. At times of recession, countries generally try to boost their exports as this stimulates employment, which has a positive effect on consumer sentiment. This on the other hand lifts consumer spending and boosts the overall economic activity.
At times of robust economic expansion, countries generally like to import more as this provides price competition, which has a deflationary effect. Strong imports also grant access to goods beyond the economys ability to meet supply, without increasing prices. This means that although a trade deficit needs to be avoided at times of economic slowdown, it may help during strong expansion.
Also keep in mind that at times of economic expansion, the trade balance of countries with export-led growth, mainly the developing nations, will typically improve, while economies with domestic demand led growth, such as the US, will experience a worsening.
Change matters most
It is also worth noting that not only the report showing a trade surplus or deficit matters, but the change from the previous period as well. For example, if the US economy was reported to have been running a trade surplus for the past five months, what would matter the most during the sixth month is the change in the amount of the surplus, rather the fact that the trade balance remains on the upside. If Americans exports have been steadily outstripping imports for the last five months and this trend seems to continue in the sixth, this would be of greater significance than the fact itself we have a surplus, thus providing the US dollar with strong support.
On the other side, if we have a decline in the surplus in the sixth month after five consecutive monthly gains, this would at least partially offset the positive sentiment from the fact that the trade balance remained at a surplus.