Terms of trade

Terms of trade

Subject: Economy

Section: External sector

Context: The surge in energy prices due to the Russia-Ukraine conflict could trigger a ‘terms-of-trade’ shock for large net energy importers like India

Concept:

Terms of trade are defined as the ratio between the index of export prices and the index of import prices. If the export prices increase more than the import prices, a country has a positive terms of trade, as for the same amount of exports, it can purchase more imports.

An abrupt change in a country’s terms of trade (e.g. -A drastic fall in the price of a primary product that is a country’s main export) can cause serious balance-of-payments problems if the country depends on the foreign exchange earned by its exports to pay for the import of its manufactured goods and capital equipment.

Factors determining terms of trade of a country

• Reciprocal demand, i.e. “the strength and elasticity of each country’s demand for the other country’s product”-If India’s demand for Russia’s Natural gas becomes more intense (inelastic), the price of natural gas (India,s import) rises more than the price of India’s export, the commodity terms of trade will move against India and in favour of Russia.
• Tariff-When a country imposes tariffs on imports from the foreign country, it implies a lesser willingness to absorb the foreign products, likely to improve the terms of trade for the tariff- imposing country.
• Tastes or preferences of the people in India shift from the natural gas of Russia  to its own Coal, the terms of trade will become favourable to India. In an opposite situation, the terms of trade will turn against this country.
• Changes in factor endowment-If there is an increase in the supply of labour in India, specialising in the production of labour-intensive commodity cloth, the fall in labour cost will lower the price of cloth (export). Consequently, more quantity of cloth will be offered by India for the same quantity of Natural gas from Russia resulting in the terms of trade becoming unfavourable toIndia. If labour becomes scarcer in this country, the terms of trade are likely to become favourable for it.
• Changes in technology-As there is technological improvement in the home country, say A, there is rise in productivity and/or a fall in the cost of producing exportable commodities, say cloth. If technological progress is labour-saving in this labour-intensive export sector (cloth industry) there will be worsening of the terms of trade.

In case this type of technical progress takes place in the import-competing sector in this county, there will be an improvement in the terms of trade. If capital-saving technical progress takes place in the labour-intensive export sector, there can still be the possibility of improvement in the terms of trade.

• Growth-As the supply of labour in the labour- abundant country A increases or growth takes place. The cost and price of exportable commodities falls leading to the terms of trade decline for the growing home country A, although the volume of trade will get enlarged.

If the supply of scarce factor capital increases, subsequent to growth, the cost and price of importable good steel will fall relative to the price of cloth. This will cause the improvement in the terms of trade for the growing home country A but the volume of trade will get reduced.

• Devaluation causes a lowering of export prices relative to import prices, the terms of trade are supposed to get worsened after devaluation of the home currency.
• Balance of Payments Position-If a country is faced with a deficit in balance of trade and payments and it has to adopt measures intended to restrict import and enlarge exports such as internal deflation, devaluation, import and exchange controls, the terms of trade are likely to get worsened.
• International Capital Flows-An increased flow of capital from abroad involves larger demand for the products of the creditor country and consequent rise in the prices of imported goods.
• Import Substitutes-If there is sufficient production of close substitutes for import goods within the home country, its reciprocal demand for the foreign products will be weak and the terms of trade are likely to become favourable for the home country.

Impact of worsening terms of trade due to Ukraine war- (impact of ukraine war already explained)

A decline in the terms of trade means the price of exports falls relative to imports. Thus, following impact:

• Imports become more expensive leading to current account deficit
• Imported inflation
• Capital outflows
• Depreciation of domestic currency
• Need for export for a given import- supply disruption
• declining living standards and lower GDP leading
• reduce export revenue and make it harder to pay foreign external debt
• Decline of forex reserve
• Stagflation-high inflation and lower output