This article briefly outlines what the terms of trade is and why it's an important economic measure. Different ways of looking at movements in New Zealand’s merchandise terms of trade, a measure of the relative prices of exports and imports of goods, are also illustrated.
A comparison is made between merchandise imports of Australian and Chinese-made goods and how the share of each has changed dramatically over the past 10 years.
What the terms of trade is and why it’s important
The terms of trade is a ratio of two price indexes: one for exports and the other for imports. The terms of trade is a measure of the buying power New Zealand has abroad for its exports. If rising, it means that New Zealand can buy more imports for the same amount of exports.
The merchandise terms of trade has shown an upward trend since the start of the 2000s. By the June 2011 quarter, the terms of trade had reached its highest level in 37 years, and was up nearly 60 percent on the lows reached shortly after the New Zealand dollar was floated in March 1985. However, in 2011 it was still 10 percent below a short-lived peak in 1973 that ended abruptly with the oil crisis in that year.
The change in the purchasing power of incomes generated by domestic production is directly related to changes in the terms of trade. Changes in the terms of trade over the long-term are an important piece of the puzzle when considering real gross domestic income (GDI) growth. Real GDI growth rates can differ significantly from real gross domestic product (GDP) growth rates at times when the terms of trade is changing (Kohli, Ulrich (2004), Real GDP, real domestic income, and terms-of-trade changes. Journal of International Economics 62, 83-106).
Recent movements in the merchandise terms of trade
The merchandise terms of trade has declined since the June 2011 quarter as export prices have fallen while import prices have remained relatively flat. The falling export price index reflects the softening in international prices for major export items in which New Zealand has specialised, especially dairy products.
Interpreting the terms of trade
Although the terms of trade formula is the ratio of two price indexes, its interpretation is essentially related to trade volumes. A rising terms of trade means more imports can be funded from the proceeds of the same amount of exports.
As an analogy, the recent situation for New Zealand's dairy industry has been that record quantities of product have been exported despite falling prices (although there have been very recent signs of recovery). The terms of trade shows the price movement and if everything else remained unchanged, it would show a decline that reflected the downward contribution of dairy export prices. If all imports were directly funded by the proceeds from exported goods, there would have to be extra volume of exports in order to maintain the same volume of imports.
When we 'slice and dice' the overall terms of trade – either by looking at the composition of our exports and imports, or our bilateral trade with key trading partners – a more dynamic change is evident.
Firstly, no analysis can ignore the impact that our dependency on oil imports has on trade-related measures. As figure 3 shows, the terms of trade is at a substantially different level when fuel imports are excluded. Notably, it shows a deeper trough and stronger recovery after the 2008 global financial crisis.
When considering the terms of trade and technological progress over time, it is interesting to compare prices for our mainly-commodity exports with those of different broad economic categories of (merchandise) imports. Figure 4 compares the overall merchandise export price index with imports of intermediate goods (which are used by the productive sector), consumption goods, and capital goods. When export prices are compared with prices of imported intermediate goods, the terms of trade has shown no growth over the past 10 years. This means that the price of our exports has not given New Zealand any more buying power for imported industrial supplies.
A comparison of prices of our exports with those for imported capital goods, such as (and especially) computer equipment, shows much larger gains. The falling price of technology goods worldwide reflects how countries with a comparative advantage in these industries have brought down costs while improving quality.
China emerges as a key trading partner
Looking at the terms of trade for our bilateral trade with two of our major trading partners, we see a rise in buying power of New Zealand exports in the Chinese market and a decline in buying power in the Australian market. Figure 5 shows that our terms of trade with China improved by over 40 percent in the past 10 years.
Australia is New Zealand's largest trading partner, but trade figures show significant growth in trade between New Zealand and China, especially since a free trade agreement came into effect in October 2008. Since then, the volume of merchandise exported to China has trebled (see figure 6).
Volume indexes of imports show goods made in China are being imported in increasing volumes, quadrupling between 2002 and 2012 (see figure 7). By comparison, the volumes of Australian-made imports have decreased by a quarter over the same period. However, about one-sixth of imports made in China are shipped from Australia, reflecting the influence of Australian-owned businesses operating in New Zealand.
This article has suggested different ways of understanding the long-term movement of New Zealand’s terms of trade, a measure of the relative prices of exports and imports. The terms of trade reached a 37-year peak in 2011, fuelled by rising world commodity prices.
The recent history of the merchandise terms of trade has been increasingly tied to dairy product export prices. The longer-term history of our terms of trade is inextricably entwined with the price of imported oil and the changing mix of New Zealand's trading partners.
The inter-relatedness of prices and volumes is clearly demonstrated when looking at the trade between two of New Zealand's major trading partners, China and Australia. There has been a rise of over 40 percent in the bilateral terms of trade with China and the volume of imports sourced from China has quadrupled since 2002.
Back to Price Index News: October 2012