Balance of Trade vs Balance of Payments

The Balance of Trade and the Balance of Payments are relevant calculations that illustrate the financial position of a country.

They reflect the transactions made by the country with the rest of the world in terms of goods, services and capital and they are used as key indicators to make economic, financial and monetary decisions.

What is Balance of Trade?

The Balance of Trade, or BoT in short, is the difference between the value of a nation’s exports and imports during a given time frame. It is also known as international trade balance, commercial balance or net exports, and it is the largest elements of a nation’s Balance of Payments.

What is Balance of Payments?

The Balance of Payments, or BoP in short, is the sum of the balance of trade, the balance of services, the balance of unilateral transfers, and the capital account.

The BoP is also known as balance of international payment and it covers all transactions that persons, companies and government entities from one country make with individuals, companies and government entities from other countries.

These transactions involve imports and exports of goods, services and capital, as well as money transfers, such as foreign aid and remittances.

This statement is a set of accounts that identify all the commercial transactions made by the nation in a specific period with the remaining nations of the world.

The Balance of Payments groups transactions in two main sections: the current account or Balance of Trade, and the capital account. The Balance of Trade records imports and exports of goods and the capital account, broadly defined, includes transactions involving capital and central bank reserves.

Sometimes the capital account is divided into capital account and financial account. The capital account reports transfers of ownership of assets and other non-productive transfers of rights or assets that are not related to a current ongoing productive activity. For example, assets such as land or machinery. On the other hand, the financial account reports transfers of financial assets. In other words, it tracks the changes in ownership of domestic and foreign financial assets.

In theory, the Balance of Payments must be always in equilibrium. Transactions in the current account are mirrored by transactions in the capital account. However, the complexity of real-life transactions usually differs from this theoretical standpoint and several adjustments have to be made to make sure the accounts are balanced.

Key Takeaways

Balance of Trade and Balance of Payments Formulas

The calculation of the Balance of Payments includes the formula of the Balance of Trade, as shown below.

Balance of Payment = Balance of Trade + Capital Account

Where,

Balance of Trade = Total value of exports – Total value of imports

Key Differences Between Balance of Payments and Balance of Trade

Scope

The Balance of Payments includes the Balance of Trade and the capital account so the Balance of Payment is a broader measure of the country’s financial situation.

In contrast, the Balance of Trade records only good-related transactions, not capital movements as it shows the amounts associated with imports and exports of goods, which is just a partial view of the nation’s finance.

Measurement

The result of the BoT may be favorable when total exports exceed total imports, which is called a surplus and it may be unfavorable when total imports exceed total exports, which is called a deficit. Or it may be in equilibrium when both amounts are approximately equal.

The Balance of Payments statement, on the other hand, includes trade transactions and inflows and outflows of services, unilateral transfers and capital transactions.

Analysis

By evaluating the Balance of Trade by itself it is impossible to determine how the deficit was financed or where the surplus went. The Balance of Payment provides those answers as every credit in the current account is balanced with a debit in the capital account and vice-versa.

When there is a large trade surplus the country is importing foreign capital as other nations pay for the goods that are being exported. On the other hand, when there is a large trade deficit and the country hasn’t received any significant capital inflows, the country’s reserves are drained.

Services

The Balance of Trade doesn’t include any services, not even the import and export of services, as the Balance of Payment covers this matter. The net result of the Balance of Trade serves as guidance to understand the net output produced by the country’s economic activities.

Economic Impact

The impact of economic and monetary policies is ultimately captured by the Balance of Payments.

For example, a government could decide to increase foreign investment in a particular sector and, therefore, the capital account will receive inflows.

Another case might be when a country decides to maintain an artificially low exchange rate and exports are encouraged.

Balance of Trade and Balance of Payments Examples

The following example shows a simplified exercise of a transaction recorded in the Balance of Payments. Let’s say that a small country has $4 billion in exports and $3 billion in imports.

In the following period, exports remain the same but imports increase by $2 billion to reach $5 billion. The Balance of Trade changed from a surplus to a deficit from one period to the other.

That deficit has to be financed in some way. The country did not increase exports of capital so the country’s gold reserves, which is an asset, were sold by the government to other countries to finance the deficit.

When selling the gold, that asset was exported to balance the deficit. A debit was recorded in the current account and a credit was recorded in the capital account as a result of these transactions.

Bottom Line

The BoT and the BoP are both important statements that indicate how the country manages its accounts and how the situation changes from one period to another in relation to inflows and outflows of goods and capital.

They both provide a comprehensive picture of the country’s transactions that help policymakers in making economic and monetary decisions. The analysis of the BoT and BoP accounts is not an easy task in real life but by understanding the what each of them mean may help analysts in predicting the potential performance of a country during future periods.

Frequently Asked Questions

What distinguishes the balance of trade from the balance of payments in economic terms?

The balance of trade refers to the difference between a country’s exports and imports of goods, while the balance of payments encompasses all economic transactions between residents of a country and the rest of the world, including trade, financial transfers, and investments.

How does a surplus in the balance of trade affect the balance of payments?

A surplus in the balance of trade, where exports exceed imports, can contribute positively to the current account component of the balance of payments, reflecting a net inflow of money from foreign markets.

Can a country have a favorable balance of trade but an unfavorable balance of payments?

Yes, a country can have a favorable balance of trade with exports exceeding imports but still have an unfavorable balance of payments if outflows from other transactions, such as foreign investments or debts, outweigh the trade surplus.

Why is the balance of payments considered a broader measure than the balance of trade?

The balance of payments is a broader measure because it includes the balance of trade along with all other financial transactions, such as cross-border investments and loans, providing a comprehensive view of a country’s economic transactions with the world.