Terms of Trade – should they rise or should they fall?

Some reflections on the development of Terms of Trade in international comparison

Recently, we discussed the importance of the “Terms of Trade” for the international competitiveness of an economy. This post compares the Terms of Trade of selected economies over time. Significant differences between countries such as Germany, the US, Switzerland, and China can be seen – and explained.

Development of the Terms of Trade since 2000

A good database for the international comparison of economic data is available from the “United Nations Conference on Trade and Development (UNCTAD)”. There, data on the Terms of Trade can be found for almost all economies in the world.

As a reminder, this indicator shows how many units of foreign products a country receives for one unit of an export good. The higher the value of this indicator, the larger the quantity of goods and services available to the country for consumption and investment after exchange with foreign countries.

To compare the development of this indicator over time between different countries, each country’s Terms of Trade are expressed as an index value. For this purpose, the Terms of Trade of the year 2000 are standardized to the value 100.

For the four countries selected here, quite different developments can be observed in some cases. While the Terms of Trade of Germany and the US reached roughly the same index value in 2019 as in 2000 (with some variations between 2000 and 2019), Switzerland’s Terms of Trade were around 15 percent higher in 2019 than in 2000. By contrast, China’s index value was about 15 percent lower.

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

The developments in Switzerland and China are particularly noticeable. Here is my explanation of these differences:

• Switzerland focuses on manufacturing and selling high-quality products. As a result, consumers worldwide are willing to pay rising prices for Swiss products. However, rising export goods prices allow only small or no increases in export volumes.
• China seems to rely more on a strategy of increasing export volumes. Larger sales volumes are usually only possible if the price falls. For China, this means a reduction in its own export prices – not necessarily absolute, but at least in relation to the prices of other products.

The Terms of Trade of these two countries can be derived from these different price developments:

• Switzerland generates increasing revenues for its export goods over time. It has to pay a falling price for Chinese products. As a result, Switzerland receives more and more Chinese products for one unit of its export goods – Switzerland’s Terms of Trade increase.
• China’s exports tend to generate declining revenue per unit of product sold. At the same time, China has to pay an increasing price for a product from Switzerland – China’s Terms of Trade therefore decline.

Another consequence of these different price developments is changing shares of global exports. China has significantly increased its share of global exports in the period under review and has been the world’s leading exporter since 2008.

This increase in exports is also because China joined the “World Trade Organization (WTO)” in 2001. Switzerland’s share, on the other hand, remained more or less constant.

Which strategy is better?

In principle, increasing one’s own Terms of Trade is beneficial: If a country receives an increasing quantity of imported goods for a given quantity of its export goods, this improves consumption and investment opportunities at home because the quantity of available goods increases. Wealth, as measured by consumption opportunities, increases.

However, it may also make sense to increase exports at the expense of reducing its own Terms of Trade: If China increases its exports, this means a higher production level at home. Demand for labor increases. This increases employment and the population’s income, which improves the living conditions of the people in China.

The decisive factor is what a country’s primary economic policy objective is:

• If income and employment levels at home are low, job creation and labor income have a high priority. In this case, it makes sense to focus on increasing export volumes. The price to pay is a decline in the country’s own Terms of Trade. However, export-driven economic growth may allow for such high economic growth that the supply of consumer goods to the population is nevertheless improved.
• If a country already has a high level of income and employment, creating additional jobs is no longer the decisive economic policy objective. Here, it is more a matter of increasing prosperity by improving its Terms of Trade. Rising prosperity can also manifest itself in people having to work less to consume the same amount of goods and services.

A reduction or deterioration in the country’s own Terms of Trade need not always be a negative development. It can have desirable effects by increasing export-driven growth. In the long term, however, a developed economy’s goal should be to obtain as many imported products as possible for its own export products.

Outlook

Even though there were some significant differences in the development of the Terms of Trade in the four economies studied between 2000 and 2019, there are also similarities. The first figure shows that the Terms of Trade developed in the same direction in some phases. For example, they rose in all four countries from 2008 to 2009. Between 2010 and 2012, they declined, only to all rise again after that. We will look at one of the key reasons for these synchronized developments in a forthcoming blog post.