In a previous post, we compared the development of the Terms of Trade in Switzerland, Germany, the U.S., and China. Although there were significant differences, in some cases, there were also times when Terms of Trade developed in the same direction. A decisive reason for this is the price of raw materials, above all oil.

Terms of Trade Developments in Switzerland, Germany, the U.S. and China

As a reminder, here is the development of the Terms of Trade (they indicate how many units of an import good a country receives for one unit of its export product) from the last blog post. If we disregard a few deviations, we can see: In principle, the ups and downs of the Terms of Trade in all four countries follow a very similar pattern:

  • Between 2000 and 2008, the Terms of Trade decline. The same applies to the phase between 2009/10 and 2011/12.
  • We see rising Terms of Trade between 2008 and 2009 and between 2011/12 and 2015.

terms of trade

How can the rectified developments in the Terms of Trade be explained?

Even though the economic structure and the level of economic development in the four economies under consideration are very different in many aspects, they have at least one thing in common:

They are all countries that are poor in raw materials – measured in relation to domestic consumption – and are therefore dependent on the import of raw materials. This applies in particular to fossil energy carriers such as crude oil, natural gas, and coal. In the following, crude oil is used as a representative example of these raw resources.

For a country that has to import this vital raw material, a rising oil price means a deterioration in its Terms of Trade: if the oil price doubles, for example, the country receives only half as much oil for one unit of its own export good as it did before the price increase.

Germany, for example, illustrates the great importance of oil prices for the Terms of Trade of a country poor in raw materials. A look at the data since 1962 (earlier data are not available) shows: In each of the three long phases in which Germany’s Terms of Trade improved (1962 to 1972, 1985 to 1998/99, and 2012 to 2020), there was a decline in the price of oil. By contrast, the two phases in which the Terms of Trade deteriorated (1972 to 1985 and 1999 to 2012) were phases in which oil prices increased.

On the other hand, for an oil-exporting country, a rising oil price means an improvement in its Terms of Trade. This can be seen by comparing Germany’s Terms of Trade with those of OPEC countries. (Organization of the Petroleum Exporting Countries)

terms of trade
terms of trade

Rising oil prices have led to a more than doubling of the Terms of Trade of the oil-exporting countries compared to 2000. Thus, in good phases with rising oil prices (good from the point of view of an oil-rich country), exchange ratios improve considerably. The quantity of goods available therefore increases sharply.

However, when there is an abrupt and massive global drop in demand for oil – as happened, for example, in the financial and economic crisis of 2008/09 and in the first months after the outbreak of the Corona pandemic – the Terms of Trade of an oil-exporting country collapse sharply. This can lead to supply bottlenecks for the population, which has adapted to and depends on imports of numerous consumer goods.

How can the dependence of the Terms of Trade on commodity prices be reduced?

Since the price of oil can fluctuate sharply and abruptly, a high dependency of one’s own Terms of Trade on this price is a significant factor of uncertainty for an economy. A deterioration in the country’s own Terms of Trade is particularly problematic.

terms of trade

If the country is dependent on certain imports, it will be difficult to finance these imports from its own export revenues if the Terms of Trade fall. If necessary, the country will have to borrow abroad – and pay back these debts at some point. How can this risk be reduced?

For oil-exporting countries, it makes sense to expand their exports to include other products. This sounds simple, but it isn’t easy, especially for a developing or emerging country. The country must make its own industry more competitive to sell its goods on the world market. However, this may fail due to the competitive advantages of the developed economies.

A resource-poor country can reduce its dependence on commodity prices by reducing its consumption of raw materials. This requires an increase in resource and energy productivity. As a result, the need for raw materials and the dependence on corresponding imports from abroad are reduced.

Price increases for natural resources will then have less weight in the calculation of the Terms of Trade. Greater resource efficiency is an integral part of an ecological transformation of the economic system. Increasing environmental sustainability then helps to stabilize the country’s own Terms of Trade.