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Factors Affecting Terms of Trade

Discuss about the International Trade and Enterprise.

The aim of this report highlights on the international trade and enterprise. The topics chosen for this study is terms of trade. Terms of trade (TOT) refers to the prices of exports of the nation relative to prices of imports. It helps in determining the health of the economy of a specific country. The measurements of terms of trade are usually recorded in an index in order to perform economic monitoring. Several factors affect terms of trade that includes size as well as quality of products (Adler and Magud 2013). This means that larger the product, the more likely is to garner higher sum. When the nations TOT improves, it signifies that for each unit of export that the nation sells, it has the ability to purchase higher units of imported products. When TOT increases, it might have positive effect on the cost-push inflation. However, this rise is indicative of reducing import prices relative to export prices. On the contrary, this increase might pose adverse impact in that the nation’s export volumes might reduce and balance of payment might worsen. When the nations TOT worsens, it signifies that the nation must export higher units for purchasing same number of imports.

The TOT that depends on the global demand for and supply of products involved, signifies how gains from trade might be distributed among the trading nations. One of the common views is that TOT has positive effect on the economic growth (Amiti and Cameron 2012). A rise in prices of export relative to prices of imports permits larger import goods to be purchased given the exports. In the last two decades, globalization has decreased the price of products and hence this benefits the industrialized nations more than developing nations. An unexpected change in nations TOT might cause problems of balance of payments if the nation relies on foreign exchange earned by their exports in order to pay for imported goods as well as capital equipment.

In the perspective of international trade, the TOT is one of the vital indicators of quality of nation’s integration into international labor distribution. The higher are TOT, the larger the nation’s advantage from development of price in foreign trade (Arndt 2015).  The economic foundation of TOT is usually represented by presence of casual relation between the ratios of prices of two goods.  It has been opined by some economist that the TOT has also been taken into account as one of the gauge of nation’s standard of living. In fact, it is also necessary to evaluate the changes in volume of foreign trade, resource allocation and labor productivity for assessing the variation in standard of living.  The TOT has great economic importance to the nation as it determines the gain from foreign trade.  If TOT moves in favor of the specific nation, it might increase gain from trade and increase nation’s income level.

It has been highlighted in the article that the TOT in Australia’s has continued to increase considerably over the last two decades, especially huge increase in prices of exports.  The TOT reached highest level near about 85% in the recent years. Over the last few years, this nation has experienced upswings in TOT (Atkin et al. 2014).  This upswing has been typically activated by industrialization of international economies, disruptions in supply resulting in increases in prices of export products. In the recent period, resource exports accounts for more than 60% of product exports and hence Australia has been considered as the biggest retailer to traded market. In addition, upswings in TOT also increased the purchasing power of the total domestic output. However, this boosted the GDP growth rate and national income of Australia (Baier, Bergstrand and Feng 2014).  In the year 2012 and 2013, investment in resource has increased significantly reaching high GDP growth rate in Australia owing to upswing in TOT. This was mainly driven by huge scale investment in iron ore as well as coal.  In the year 2016, the TOT of Australia lowered by 50%, representing significant reduction in households purchasing power. Brenton and Pelkmans (2016) opines that rising commodity prices owing to softening Chinese demand as well as rising global supply hammered export prices and crimped growth of national income in Australia. This decrease in TOT was accompanied by depreciation in exchange rate thereby making exports more competitive. Macroeconomic policy plays vital role in how TOT cycles influences the economy of Australia (Bullen, Kouparitsas and Krolikowski 2014).  As exchange rate and TOT apt in moving closely together, reduction in TOT is also accompanied by real depreciation. In fact, variation in the taxation system in this nation has increased sensitivity of revenues to changes in TOT as well as economic activity.  Not all the parts of the Australian economy have directly benefitted from upswing of TOT and hence changes in macroeconomic policy helped the nation in achieving proper macroeconomic outcomes. Recent study however reflects that substantial improvement in TOT of Australia over the past few years appreciates Australian dollar.

Relationship Between TOT and Economic Growth

Figure 1: TOT of Australia

Source: (Citeseerx.ist.psu.edu. 2017)

According to the report published by International Monetary Fund (IMF), it has been seen that China’s TOT have reduced significantly over the last two years. It is mainly because of two reasons that includes-

  • Weaker domestic investment mainly accounts for 40-50% of reduction in imports.
  • Weaker exports also accounts for 40% of reduction in imports.

It has been estimated by the IMF researcher that decline in import –export trade in China is mainly because of rebalancing and weak global demand. This in turn decreases import demand in China. As the Chinese economy recovers from the global financial crisis (GFC), the demand for export s well as imports increased (Manova and Yu 2012). It has been seen from the recent study that exports of this nation usually relies on the processing trade, which has been driven by FDI (foreign direct investment). In addition, the membership of China in WTO has strengthened as well as improved multilateral trading system (Costinot, Lorenzoni and Werning 2014). It also promoted trade as well as economic development. However, after the entrance in WTO (World Trade organization), the barriers in trade have decreased and imports have steadily increased in this nation (Ville 2016). After becoming the member of WTO, this country continued to decrease trade restrictions (Ludema and Mayda 2013). Dismantling of barriers in trade led to restricting of many industries, which previously had government protection including automobile, electronics and chemical. The FDI in import as well as exports account for higher share in trade and low-priced labor forces has been the main cause that attracts FDI. The international investors put end value commodities into this nation for decreasing the export price (Kelly and Cava 2014). They mainly export those commodities that are processed with imported raw goods and hence make this nation price taker. TOT in China averaged to 100.42 index points from the year 2005 to 2017.  Furthermore, the trade volumes have increased in the past few years at a rate of 18.1% and 17.7% for exports as well as imports. During this period, the balance of trade had been in excess. Moreover, the share of this nation in world trade as well as its world ranking has increased steadily. In the year 2012, its volume in trade accounted for near about 11.3%of world trade, leaving behind other emerging nations. Besides, internal trade of this nation has developed faster but it remains lesser than US interstate trade.

Japan is one of those countries whose TOT has deteriorated for over the past 10-15 years.  It has been predicted by some economist that macro problems have confronted this nation (Korhonen 2013). The resources were mainly allocated from manufacturing to service sector and hence growth of output slowed. Recent statistics highlights that TOT in Japan reduced to 102.40 index points in 2017.

Figure 2: TOT in Japan

Source: (Korhonen 2013)

The main reason behind deterioration of TOT is trade policy of this nation. For several years, export promotion has been one of the biggest problems in this nation’s government policy. The method of export promotion of this nation has mainly taken two pathways. Firstly, they developed world class industries in order to substitute for imports. Secondly, they provided incentives for the entities to export. In fact, this nation also prohibits restrictions on certain imported products including firearms, counterfeit currency, narcotics etc that violates laws of intellectual property. In addition, imposition of restrictions on certain goods including medical products, agricultural products and pharmaceuticals by this country also led to worsening of TOT. As most of the products did not require import license and hence can be freely imported into this nation, these products imposed adverse effect on the Japan industry.

Importance of TOT for Nation's Income Level

The TOT of UK has improved over the past 20 years, signifying that the price of the exported products have been rising in relation to the price of the imported products. This has mainly occurred due to the fact that globalization has inclined to have less affect on export price of the invisibles of this nation as compared to its impact on the visible import price (Feenstra 2015). TOT in the UK has increased to 101.8 index points in this year. The TOT in Japan averaged to near about 167.44 index points for the period 1960 to 2017. Trade is vital for this country as it helps the economy in growing as well as supporting standard of living. Moreover, fluctuations in this nation’s exchange rate influence the export prices relative to imports. Recent study also reflects that the trade volumes in this country have increased significantly to global trade. In fact, the Tot of UK did not deteriorate even during the global financial crisis in the year 2007 (Tang, Snowden and Höök 2013). Weaker pound had encouraged their exporters in putting up their profit margins as well as increase their prices of products.

Figure 3: TOT in UK

Source: (Tang, Snowden and Höök 2013)

TOT in US has increased to near about 100.14 index points in the present year and has improved over the decades. This nation has been considered as one of the top three world importers as well as exporters.  After the Great Depression, this nation has emerged as one of the most vital trade policy makers and is now the partner of the international trade. This includes GATT (General Agreement on Tariff and Trade) and the WTO. The trade policy of this country has varied widely over the years. As one of the major developed country, US relied mainly on both the import of raw goods and export of final products. This nation basically developed lower rate of savings rather than its trading partners, which tended to have higher trade surplus. In addition, changes in TOT of US and its relative tradable prices make substantial contribution to GDP (Gross Domestic Product) growth rate of this country. Over the past few years, the TOT in US averaged to 113.48 index points.

In the past ten years, Germany had experienced improvement in TOT and it accounts for more than half of the foreign trade in EU (European Union). This nation’s exports mainly focuses on industrially manufactured products and services. In addition, integration of EU has highly intensified intra- European trade with near about 69% of this nation exports shipped to other countries in Europe. In fact, the trade surplus occurs in this nation mainly because of two reasons that includes-

  • The currency that this nation shares with other countries might not be at the right level and hence it is too weak to be consistent with their trade.
  • The trade surplus of this country has further increased over the years due to the tight fiscal policies, which in turn suppresses the nation’s domestic expenditure including expenditure on imports.

Trade in India has generally grown at higher rate in comparison to GDP growth rate over the last two decades. TOT in India averaged to near about 79.46 index points from the year 2000 to 2016.  The economic development of India in the initial period has worsened both commodity as well as income TOT. The condition of this nation at that period illustrates that the tendency of TOT to move against underdeveloped nations has been mainly due to less capacity of these nations for shifting their resources. During the financial crisis, TOT of this nation collapsed alongside international trade. During this period of global financial crisis, both the exports as well as imports contracted for around 20%. All the activities relating to exports as well as imports are mainly governed by the foreign trade policy (FTP) that aimed at increasing the nation’s exports and uses expansion of trade as vital instrument of economic growth. However, as part of FTP strategy of expansion in market, this country has signed comprehensive economic partnership agreement with other nations that might provide increased market access to this nation’s exports. The government of India also played vital role in improving TOT of this country. They had announced scheme of interest subsidy for their exporters for boosting exports as well as exploring new markets. Therefore, boosted by FTP, exports of this country has been predicted to reach by USD $750 billion according to FIEO (Federation of India exports organization). In addition, it is expected that implementation of FTP by 2020 might double this country’s share in the global trade from the present 3% level.

Analysis of Australia's TOT

TOT in Indonesia has increased to around 106.25 index points in the present year and averaged to 102.03 index point over the last two decades. In the year 2015, bilateral trade in products between Indonesia and EU accounted to near about euro 25.3 billion, with EU imports and exports worth euro 15.4 billion. Indonesia has been considered an exporter of mineral as well as agricultural goods.  However, the combination of high concentration of exports in certain primary goods and improvement in TOT for major export products might impose barrier to accomplishment of export share by manufacturing sector. This share remains small despite Indonesian manufacturing sector achieves gain in export share. Even the imports in this country have increased rapidly owing to increase in export earnings.

TOT in South Korea averaged to near about 155.43 Index points during the past few decades. In the year 2016, this nation has exported $483 billion as well as imported $389 billion, which resulted in positive balance in trade of $93.7 billion. During the past few years, this country’s exports have declined at an annual rate of -6.15%, therefore from $563 billion in the year 2011 to $483 billion in the year 2016. Likewise, the imports of this country have reduced during the past five years at annualized rate of -7.18%, thereby $501 billion in 2011 to $389 billion in 2016. However, the TOT of this country has remained stable for the last few years.

Figure 4: TOT in Korea

Source: (Wagner 2012)

The TOT of the nation is mainly influenced by several factors, which are illustrated below:

  • Elasticity of demand- This factor for exports as well as imports of a nation influences its TOT. If the country’s demand for exports is less elastic in comparison to their imports, the TOT might be favorable as the exports might command high price with respect to imports (Wagner 2012).  For example, here are two nations, Germany and Indonesia producing linen and cloth respectively.  If the demand of Germany for Indonesia’s cloth becomes highly intense, the cloth price increases more than linen price. Thus, the TOT will move in favor of Indonesia but against Germany.
  • Elasticity of supply- This factor also affects TOT of the country. If the nation’s supply of exports is highly elastic than their imports, the TOT might apt to be favorable.
  • Variation in factor endowments- This factor might increase exports or decrease them. Unchanged tastes of the consumers might lead to change in TOT.
  • Devaluation- Devaluation refers to reduction of exchange rate of the domestic currency with respect to other currencies. This signifies that the exports will be cheaper and imports dearer. As a result, it might lead to deterioration or improvement in TOT of a particular nation that devalues its currency based on elasticity of demand as well as supply of products entering foreign trade (Amiti and Cameron 2012).  The TOT might be favorable if the demand elasticity of commodity of nation’s exports as well as imports is larger than supply elasticity of commodity of nation’s exports as well as imports. Therefore, devaluation might be successful if gross barter term has become adverse. Manova and Yu (2012) opines that the theory of TOT helps in assessing the impact of devaluation.
  • Tariff- Imposition of tariff restrictions as well as tariff duties helps in improving the TOT of the nation. The main reason behind this is that tariff restrictions decreases the nation’s imports and increase its imports. However, specific quantity of nation’s exports will fetch larger quantity of their imports and thus leads to improvement in nations TOT.
  • Advancement in technology- Technological changes affects the TOT of the nation. This means that if the country introduces new technology for trading, it will help them in improving their TOT.
  • Economic development- The economic development has mainly two kinds of effects-
  • The demand effect- It refers to rise in import demand due to rise in income that is connected with economic development.
  • The supply effect- It refers to rise in supply of the import substitutes or competing products.

The net impact of economic development is mainly based on the level of these two effects. Furthermore, the development of economy might lead to rise in output mainly

  • Structure of the economy- The economic framework of the nation, which means the products entering into trade also affect the TOT. If the nation manufactures as well as exports raw materials, the TOT might be against that nation as the prices of products had shown declining tendency in last few decades (Panagariya 2013). On the contrary, the nation manufacturing exporting industrial products will apt to have favorable TOT as the demand as well as prices of industrial products had shown a rise in international markets.
  • Degree of competition- if the nation enjoys monopoly power for its exports and hence there are no other sources of import supply, then it might have favorable TOT.

Conclusion

From the above report, it can be concluded that TOT in Australia is better than other countries. Over the years, the nation’s trade policy has improved their TOT. Although other countries have fluctuations in TOT, the government of the respective countries has adopted certain policies in order to improve trade and economic growth of their nation. There are certain limitations regarding TOT of the nation. TOT must not be used in synonymous with Pareto economic welfare. For understanding the nation’s changes in social utility, it is vital to consider changes in trade volume, productivity, allocation of resources and changes in flow of capital.  In addition, the export prices from the nation also influences their currency value, which in turn be heavily affected by interest rate.  If the currency value of the particular nation is increased owing to rise in interest rate, one nation might expect improvement in TOT. However, this might not be necessarily mean improved living standard for the nation since rise in the export price that other countries perceives might result in lower export volume. Hence, the exporters of a particular nation might essentially be struggling in selling their products in foreign market even though they enjoys higher price. The country adopts several policies for achieving improvement in trade balance – some of the nation focuses on the changing demand growth and others might look in improving supply side competitiveness of the economy

References

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Amiti, M. and Cameron, L., 2012. Trade liberalization and the wage skill premium: Evidence from Indonesia. Journal of International Economics, 87(2), pp.277-287.

Arndt, S.W., 2015. Super-specialization and the gains from trade. In Evolving Patterns in Global Trade and Finance (pp. 91-96).

Atkin, T., Caputo, M., Robinson, T. and Wang, H., 2014. Macroeconomic consequences of terms of trade episodes, past and present.

Baier, S.L., Bergstrand, J.H. and Feng, M., 2014. Economic integration agreements and the margins of international trade. Journal of International Economics, 93(2), pp.339-350.

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Citeseerx.ist.psu.edu. (2017). Cite a Website - Cite This For Me. [online] Available at: https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.638.3073&rep=rep1&type=pdf [Accessed 27 Dec. 2017].

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