Trade Balance, Current Account and Capital Flows

What you will learn

• How the trade balance, current account and financial account fit together.
• Which releases publish these numbers in the US, Germany and the euro area.
• Why financing a deficit links external balances to currencies and bond yields.
• How to interpret a trade surprise without over-reading it.

Explanation

The balance of payments records all transactions between residents of a country (or the euro area) and the rest of the world. Its two main parts balance by construction: the current account and the financial account (plus a small capital account and an errors-and-omissions line). A country that buys more from abroad than it sells must receive money from abroad to pay for it: a current-account deficit is mirrored by a financial-account inflow.

The four parts of the current account

• Goods balance (the "trade balance" in most headlines): exports of goods minus imports of goods.
• Services balance: tourism, transport, software, financial and business services.
• Primary income: dividends, interest and profits earned on foreign assets minus those paid to foreign investors, plus cross-border wages.
• Secondary income: transfers with nothing in return, such as remittances and EU budget contributions.

Germany's surplus comes mainly from goods and primary income; the US deficit is mainly a goods deficit partly offset by services. A current account is quoted as a percentage of GDP; the European Commission's macroeconomic imbalance procedure uses indicative thresholds of a three-year average deficit of 4 % or surplus of 6 % of GDP.

The releases

In the US the Census Bureau and the Bureau of Economic Analysis publish the monthly international trade in goods and services report about five weeks after the month ends and the quarterly current account about eleven weeks after the quarter. The advance goods trade balance arrives a week earlier and feeds GDP nowcasts (lesson 6), because net exports are a GDP component. The Treasury's monthly TIC data (Treasury International Capital) show foreign purchases of US securities. Destatis publishes the monthly German Außenhandel (foreign trade) report and the Bundesbank the full balance of payments; Eurostat and the ECB cover the euro area. Trade data are nominal, so an energy-price jump can widen a deficit without any change in volumes; check the volume indices.

Financing and the link to markets

A deficit is financed by some mix of foreign direct investment, portfolio investment (foreigners buying bonds and shares) and other investment (bank loans, deposits), or by running down reserves. Direct investment is sticky; portfolio flows can reverse quickly. Three channels follow:

1. Currency: a widening deficit means more of the currency is sold to pay for imports; unless inflows rise, the exchange rate tends to weaken over time. For a reserve currency such as the US dollar this link is weak and slow (see the macro foundations course).
2. Bond yields: a deficit country depends on foreign bond buyers; if their demand falls, yields must rise to attract them. TIC data and auction statistics show this.
3. Vulnerability: for emerging markets with foreign-currency debt, the deficit relative to reserves is a classic stress indicator (the emerging-markets course uses it in a scorecard).

Monthly trade prints move markets mainly when they change a GDP nowcast or when a country is already under scrutiny.

Worked example

Hypothetical example: a euro-area country reports for one quarter (billions of euros) goods exports 120, goods imports 105, services balance −5, primary income +8, secondary income −4; quarterly GDP 1,050. Assumptions: round figures; valuation effects ignored.

1. Goods balance = 120 − 105 = +15.
2. Current account = 15 + (−5) + 8 + (−4) = +14.
3. As a share of GDP: 14 / 1,050 = 1.3 % (the same ratio on an annual basis: 56 / 4,200).
4. Financing: with a surplus of 14, residents acquired about 14 of net foreign assets in the financial account, for example by buying foreign bonds.

Now suppose energy import prices rise 20 % and energy was 25 of the 105 import bill. New imports = 105 + 0.2 × 25 = 110; the goods balance falls to +10 and the current account to +9 (0.9 % of GDP). Volumes did not change, yet the headline surplus shrank by a third; the volume index would show exports and imports flat in real terms.

Market reading: a smaller surplus caused by import prices is a terms-of-trade loss, not a competitiveness problem. The same fall caused by collapsing export volumes would be a growth problem and would matter more for equities and rate expectations.

Common mistake

Practice activity

On paper: a country reports for a year (billions) goods exports 400, goods imports 460, services balance +35, primary income −10, secondary income −15; GDP 2,000. (a) Calculate the goods balance and the current account as a percentage of GDP. (b) The financial account shows net portfolio inflows of 60 and net direct-investment outflows of 10. Which financing is more fragile, and why does it matter for bond yields? (c) If import prices fall 5 % with volumes unchanged, what happens to the goods balance?

Key takeaways

• Current account = goods + services + primary income + secondary income, mirrored by the financial account.
• Trade data are nominal; check volumes before concluding anything about competitiveness.
• The mix of direct, portfolio and other flows determines how fragile the financing is.
• External balances work on currencies and yields slowly, except under stress.

Next step

Next you put all releases together and study how markets actually react: the reaction function, consensus dispersion, pricing-in and the first and second moves across rates, equities and currencies.