- The Terms of trade refer to the relative price of exports/imports.
- A decline in the terms of trade means the price of exports falls relative to imports. Imports become more expensive.
- Typically a country will have lower living standards and less ability to import.
Impact of decline in terms of trade on a developing economy
Suppose a developing country exports coffee beans and imports manufactured goods.
- A decline in the terms of trade will mean a country will see the price of coffee beans fall relative to the price of imported manufactured goods. This means it has to export relatively more coffee beans to get the same quantity of manufactured goods.
- A prolonged fall in the terms of trade could be seen as a problem because it can lead to declining living standards and lower GDP.
- It could also reduce export revenue and make it harder to pay foreign external debt. This would be a problem for developing economies with high external debt. TO meet the debt repayments may require a relatively higher percentage of national income on meeting repayments in foreign currency.
Cost of decline in terms of trade
World Bank estimates suggest that between 1970 and 1997 declining terms of trade cost non-oil-exporting countries in Africa the equivalent of 119 percent of their combined annual gross domestic product (GDP) in lost revenues. It will also be more difficult to earn more foreign currency to pay external debt. [1. State of Agricultural Markets FAO]
Many developing countries concentrate on producing primary products, but according to The Prebisch-Singer hypothesis, there is likely to be a fall in the terms of trade when you concentrate on primary products. This is because:
- Low income elasticity of demand. As incomes rise, demand doesn’t rise so much.
- Increased productivity (fertilizers e.t.c.) increases supply and reduces price.
Between 1961 and 2001, the average prices of agricultural commodities sold by LDCs fell by almost 70 percent relative to the price of manufactured goods purchased from developed countries [2. The State of Agricultural Markets 2004 FAO ]
- A decline in the terms of trade is not necessarily a bad thing. For example, a decline in the terms of trade may occur due to a devaluation in the exchange rate. This devaluation may enable a country to regain competitiveness and increase the quantity of exports. For example, the UK in 1992 benefited from a decline in the terms of trade.
- The impact of a decline in the terms of trade will depend on the elasticity of demand. If demand is elastic, the lower price of exports will cause a bigger % increase in demand.
- Some LDC’s have seen an improvement in terms of trade because of rising price of commodities and food post-2008. It is not always LDCs who see a decline in the terms of trade.
- It is important to distinguish between a short-term decline in terms of trade and a long-term decline. A long-term decline is more serious for reflecting a fall in living standards.