How trade works can be a confusing topic that directly impacts your life, whether you're buying a cell phone or buying a car. An increased understanding of how balance of trade works can help you understand more about the world at large. 

What Is a Balance of Trade?

Balance of Trade (BOT), also known as trade balance is the total sum of a nation's exports minus the value of its imports. Its value is expressed in currency form. A country is said to have a trade imbalance or deficit if its imports are greater than its exports.

Imports refer to goods and services a country's people buy from foreign companies. Goods made overseas by a country's own companies and are returned to the country for sale are also considered imports, even if the revenue benefits the importing country.

Exports are goods and services a nation's companies sell to people overseas. There are advantages to both importing and exporting goods, but a prolonged trade imbalance, also known as a trade deficit, is generally viewed as a negative for a country's economy.

What Is a Trade Deficit?

A trade deficit is when a country's imports exceed its exports. In other words, more products manufactured abroad are entering the country than products being manufactured domestically are shipping overseas.

Is It Bad to Run a Trade Deficit?

Theoretically, a trade deficit can hurt a country's employment levels if its goods aren't purchased abroad. That's because the country whose goods don't enjoy foreign or domestic demand might lose jobs in manufacturing those goods, potentially causing the economy to suffer. That happens when foreign countries make and sell the same products at a much lower price than domestically-manufactured goods. Domestic products can't compete, so more of the manufacturing is outsourced to the country that produces it at the lowest cost.

This scenario has played out for decades in the U.S., where critics have blamed free trade treaties like the North American Free Trade Agreement (NAFTA) for enabling foreign trade partners to sell their goods into the U.S. more affordably than domestic manufacturers. Many economists say the U.S. economy experienced net growth as a result of increased free trade between the U.S., Canada and Mexico under the treaty. However, NAFTA caused an exodus of about 700,000 manufacturing jobs from the U.S. to Mexico, according to the AFL-CIO. The unions also blame the treaty for increased inequality, stagnant wages and weak social protections in all three countries.

Despite recent moves to rewrite the treaty and reduce regulations in the U.S. in order to bring back manufacturing jobs to the U.S., it is difficult to reverse outsourcing of production from a country with lax labor regulations and much lower wages than the U.S. Since consumers are free to purchase the most affordable goods and prefer cheaper imports if they're of comparable quality, U.S.-made goods are at a disadvantage. And once lost, it is challenging to regain the manufacturing skills lost to outsourcing. Raising tariffs on foreign imports as the Trump administration has recently done can also hurt the domestic consumer and producers by causing inflation and sparking a trade war that can cause foreign buyers to raise tariffs on U.S. exports. U.S. companies will also see the cost of foreign goods they use in manufacturing their products increase, which can further hurt U.S. companies' competitiveness.

Another downside to a trade deficit like that in the U.S. is that it can devalue the country's currency. If a country isn't exporting much, then foreign buyers don't need to buy that country's currency to purchase its goods. Low demand for the currency causes it to fall. Devalued currency may also cause inflation.

Why the U.S. Trade Deficit May Not Hurt the Economy

Although the U.S. has had a trade deficit for decades, it has been spared somewhat from severe currency devaluation and inflation by the fact that the U.S. dollar (USD) is a global reserve currency. That means that most countries in the world hold large quantities of USD with which to conduct international trade and investments. Bolstering its position as the reserve currency, the USD makes up a majority of all foreign exchange trades.

Also, U.S. Treasurys are considered among the world's safest investments, and foreign governments purchase the debt with USD from their trade with the U.S. One of these governments is China, which has a large trade surplus against the U.S., so it has a huge amount of USD which it uses to buy U.S. Treasurys.

China became the U.S.'s largest creditor in 2008, and has since remained the largest holder of U.S. national debt, with about $1.15 trillion as of the third quarter of 2018. Japan is the second-largest, holding about $1.023 trillion.

The U.S. has long had a trade deficit. Its annual deficit increased by $56.4 billion to $807.5 billion in 2017. Meanwhile, in 2017 China had a trade surplus of about $419 billion.

The U.S. deficit has deepened over the past years, and the U.S. Census Bureau and the U.S. Bureau of Economic Analysis said monthly goods and services trade deficit for October 2018 increased by 1.7% to $55.5 billion, up $900 million from $54.6 billion in September.

So why isn't the U.S. economy crumbling under the weight of all this debt in the hands of foreign governments?

As explained above, the U.S. dollar is supported by its status as the global reserve currency. That means it's not easily devalued as the currency of any other country with a massive deficit would be, and therefore also avoids runaway inflation.

The inflow of affordable products from places like China into the U.S. also helps the consumer and keeps inflation in check.

Another factor that might be helping the U.S. keep it together is the perception that, despite its huge trade imbalance, its many business are global powerhouses that are thriving, and that may not be reflected by the trade numbers.

Although the U.S. borrows to fund its trade deficit, there is borrowing that depletes a country and borrowing that helps it invest for the future. The U.S. may benefit from the general perception is that it is a global leader whose businesses invest in ways that advance the country. If the U.S. is borrowing to fund technology and machinery that will lead to economic growth, then running a deficit for investment isn't necessarily a bad thing.

Given its large corporate interests and also being the world's financial capital, the U.S. economy is complex and the simple trade balance equation may not capture the full trade picture.

For instance, large U.S.-based corporations like Apple (AAPL - Get Report)   manufactures its components and products overseas, then sells its products in the U.S. as imports even though the company revenue is booked in the U.S. That benefits the economy here, but it's not reflected in the U.S. balance of trade.

How Much Power Does China's Trade Surplus Give It Over the U.S.?

China has, in the past, hinted that it could crush the U.S. if it wanted to by selling its massive U.S. Treasury holdings. It has held this threat over the U.S. to try to gain advantage in trade negotiations; however, as one of the largest holders of U.S. debt, China would suffer the most after America if it tried to crater the Treasury market. Since there isn't really another bond market of equal size, stability or liquidity, if China were to try to sell a large portion its Treasurys, it would be difficult for the behemoth to find a counterparty to take the other side of a gigantic sale.

Assuming it did find someone to buy its Treasury holdings, China would have to then find somewhere safe to invest billions of dollars. Even if China were to buy up the sovereign debt of all the world's developed markets, the sudden surge in demand might drive yields in those markets negative. China would have to pay to own their debt. It seems unlikely the sovereign would want to make such a move as interest rates are rising in the U.S.