What is the terms of trade index?

What is the terms of trade, and how is it calculated?  

The terms of trade is an index measuring the price of a country’s exports relative to the price of its imports. The terms of trade rise (improve) when the price of a country’s exports increase relative to the price of its imports, and decline (deteriorate) if import prices increase relative to export prices.

Why does it matter?  

Terms of trade matters because it measures the purchasing power of exports relative to imports. A country experiencing an improvement in its terms of trade can buy more imports with the same quantity of exports, hence gaining purchasing power. In contrast, a country experiencing a deterioration in its terms of trade (for instance, an oil importer when oil prices rise) is transferring purchasing power abroad.

What causes fluctuations in the terms of trade?  

The terms of trade is affected by all factors influencing the price of internationally traded goods and services. Among those, two important factors are fluctuations in exchange rates and commodity prices, which are notoriously volatile.

For instance, an appreciation of the domestic exchange rate can lead to a reduction in the domestic price of imported goods, if those goods are priced in foreign currency, and hence improve the terms of trade. For instance, an American importer buys wine from France for 10 euros a bottle. In year t, 1 euro buys 1.1 dollars. However, in year t+1, 1 euro buys 1 dollar. That means that the bottle of wine will cost $10 in year t+1 instead of $11.

For some countries, however, this channel is not in action: If a country exports commodities priced in dollars, fluctuations in its exchange rate will affect the domestic price of its exports and imports symmetrically. Consider, for example, the case of Nigeria, a country relying almost exclusively on oil for its export revenues. Its oil is priced and traded globally in U.S. dollars. Fluctuations in the naira exchange rate against the dollar have no impact on the U.S. dollar price of its oil exports. Similarly, its imports are also priced in foreign currency, and hence their U.S. dollar price is unaffected by fluctuations in the naira-dollar exchange rate, even though domestic prices are.

Fluctuations in commodity prices are a particularly important driver of the terms of trade. Russia’s invasion of Ukraine in February 2022 prompted a series of events that impacted Europe’s energy landscape and inevitably its terms of trade. Preceding the conflict, Russia was the largest exporter of energy to the European Union, in the form of oil as well as gas. After the start of the war, a combination of supply disruptions and international sanctions on Russia caused gas prices to spike, while oil prices rose as well. As a result, imported energy costs skyrocketed across Europe. Due to Europe’s heavy reliance on imported energy, its terms of trade worsened, resulting in a net transfer of domestic income abroad and a sharp slowdown in economic activity. The reverberations of the war on the terms of trade and economic activity were also severe in many emerging and developing economies relying on imports of energy as well as wheat, whose price also spiked in 2022.

Another way fluctuations in commodity prices can significantly impact a country’s terms of trade is exemplified by Chile, the world’s largest copper exporter. Copper accounts for about half of Chilean exports of goods, highlighting the economy’s sensitivity to fluctuations in its price. From April 2020 to April 2021, copper prices surged from $2.29 to $4.23 per pound, doubling over a relatively short period. As a result, Chile’s terms of trade improved by around 30% between the first quarter of 2020 and the second quarter of 2021, as export prices rose sharply relative to import prices. This positive shock increased Chile’s domestic income, boosting its purchasing power and domestic demand, and was accompanied by a 20% appreciation in the Chilean peso relative to the dollar between April 2020 and April 2021, reflecting the improved prospects for the Chilean economy.

How has the United States’ terms of trade changed over time? 

The U.S. terms of trade declined in the 1970s when oil prices went up. In 1973, the Organization of Petroleum Exporting Countries (OPEC)’s 1973 oil embargo precipitated an oil crisis. Coupled with the 1979 Iranian Revolution, both events resulted in a 300% increase in oil prices. At the time, the U.S. was a net oil importer; hence the increase in oil prices meant higher import prices and worsening terms of trade.

In contrast, the U.S. terms of trade improved after 2020. This was also a period of sharply rising oil prices, but U.S. domestic oil production has risen substantially, and the U.S. has become a net energy exporter. The terms of trade was supported by a strong dollar and by shifts in global goods prices that impacted its exports and imports differently. For instance, consumer goods are a relatively high share of U.S. imports, and their prices rose much more modestly than the price of U.S. exports, which are more concentrated on intermediate goods and capital goods. The improved terms of trade have cushioned the deterioration of the U.S. trade balance, offsetting in part the much faster growth of the volume of U.S. imports (triggered by the strong recovery of U.S. demand) compared to U.S. exports.