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Understanding The Importance Of ‘Terms Of Trade’ As A Macro Economic Indicator

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Introduction

Terms of Trade is a direct and useful measure of an economy’s International Trade health and gives us a good measure of how fast capital is moving in or out of the country. Terms of Trade make analyzing Balance Of Payments and, more specifically, Current Account Balance easier. Understanding of Terms of Trade can help us better analyze the current liquidity of the economy and its changes in a more crude way.

What are Terms Of Trade Indices?

Terms of Trade is the ratio of its Export Prices and Import Prices. It is the ratio of money received on exports to money spent on imports. If there is an individual’s analogy to be made, then it would be the ratio of an individual’s monthly income to his monthly expenses. Mathematically, it would be the number of export goods that can be purchased per unit of import.

Terms of Trade ratio expressed in percentages, and hence the ratio is multiplied by a hundred. A TOT figure above100 indicates that the country is receiving more on its exports than on its income and vice-versa.

When a country has a TOT figure of more than 100, it means that it is receiving more capital on exports compared to sending capital out on imports. Hence, on an overall basis, capital is flowing into the country. Higher the ratio, the faster the rate at which capital flows into the country. It ultimately translates to the pace at which a country is becoming wealthy and liquid.

When a country has a TOT figure less than 100, it means capital is flowing out of the economy, and its import expenses exceed that of its export revenue generated. Continued periods of TOT figures less than 100 will drive the economy to a vicious debt cycle from which recovery may be difficult. The ratio will tell us how fast the capital is depleting from the economy and is nearing a financial crisis. Countries prefer to have a ratio above 100.

The ratio tells us the rate at which the economy is accumulating capital. On the global market place and International Trade, the ratio will determine what portion of the world’s wealth goes to each country. In other words, based on the demand and supply on the international markets, the ratio will tell us how profits from international trade will be distributed amongst the participating countries.

How can the Terms Of Trade numbers be used for analysis?

Since TOT is a ratio change in TOT, figures can imply multiple things. An improvement in TOT figure could mean:

  1. Export prices have increased in contrast to Import prices being stagnant or dropped.
  2. Export prices would have dropped but not as sharply as import prices. Both dropped but not to the same degree.
  3. Export prices would have stayed the same while Import prices would have dropped.

All the above scenarios can lead to an improvement in the TOT figure. Hence, simple changes in TOT figures cannot be directly used to draw economic conclusions. It is crucial to understand the factors that have resulted in a change in TOT numbers. It is crucial to know whether the change is a consequence of a short-term shock or development or a consistent long-term trend that will persist throughout the coming periods.

TOT is susceptible to multiple economic factors, some of which are:

Exchange rate: A decrease in exchange rate adversely affects imports and benefits exports and vice versa. Imports become costly, and exports become cheap, adversely affecting TOT.

Inflation: The inflation rate across different economies and different sectors affect different economies having different export and import portfolios. For example, a sharp increase in Iron Ore prices can greatly benefit Australia, whose chief exports are Iron Ore, while it can affect importing countries like China and Japan adversely. So inflation across sectors have different impacts across economies and within the country amongst different sectors.

Demand and Supply: Increase in demand, coupled with the availability of those resources also affects TOT as exports and imports are a function of demand and supply. Scarcity increases prices and oversupply decreases the same.

Quality of Produce: Size and quality affect the pricing of products. A high-quality product is likely to cost more and benefit the exporter more. Hence, the portfolio of the country’s exports and imports determines the TOT fluctuations of different product grades.

Trade Tariffs: Protectionist strategies from Governments lead to putting trade barriers on imports. The political and trade ties between countries can also affect the long term trend of TOT figures for a given economy.

Portfolio of Exports and Imports: What types of Goods and Services a country exports and imports also matter. Countries that export goods and services that are more of primary importance (ex: food and energy) tend to always have high demand and TOT ratio more than 100 both within the economy and on the global economy.

Impact on Currency

When the TOT figure is above a hundred, it implies domestic currency is flowing into the country and creating a deficiency in the global market. Hence, higher TOT figures will increase its currency demand and thereby leading to currency appreciation. On the other hand, a continued TOT less than 100 indicates the world is being supplied with domestic currency and therefore leads to currency depreciation.

It is a coincident indicator and is more useful as a long-term trend indicator rather than short-term changes. The indicators affecting TOT would have been identified through Trade agreements or other media sources in general and hence, is a mild-impact indicator.

Economic Reports 

The Bureau of Economic Analysis publishes its TOT figures in the National Income and Product Accounts every quarter of the year on its official website. Below is a figure for an illustration of the same:

We can also find the aggregated TOT reports for the OECD countries on the official website. The World Bank also aggregates and maintains TOT data for most countries on its official website.

Sources of Terms Of Trade

For the US, we can find the Terms of Trade in their National Income and Product Accounts here:

BEA – National Income and Product Accounts

OECD – Terms Of Trade

World Bank – TOT

We can also find Terms of Trade Index for many countries categorized here.

Impact of the ‘Capacity Utilization’ news release on the price charts

In the previous section of the article, we learned the Terms of Trade economic indicator and understood its significance in an economy. The ToT Index measures the ratio of an export to the price of an import, per commodity. A country that heavily relies heavily on exports, this number gives an important hint of the nation’s growth. Even though the Terms of Trade is useful in determining the balance of trade in a country, it does not have a major influence on the GDP of the economy. Therefore, investors don’t give much importance to the data during the fundamental analysis of a currency.

Today, we will be analyzing the impact on Terms of Trade on different pairs and witness the change in volatility due to the news release. The below image shows the latest Terms of Trade data of New Zealand that indicates an increase in the value compared to the previous quarter. A higher than expected reading is considered to be positive for the currency while a lower than expected reading is considered as negative. Let’s see how the market reacted to this data.

NZD/USD | Before the announcement:

We shall start with the NZD/USD currency pair to examine the impact of Terms of Trade on the New Zealand dollar. In the above price chart, we see that the market is in a strong downtrend before the news announcement with increased volatility. Currently, the price is at a key technical area, which is known as the ‘demand’ area, and hence we can expect buyers to come in the market at any moment. Thus, once needs to be cautious before taking a ‘short’ trade.

NZD/USD | After the announcement:

After the news announcement, the market moves lower and volatility increases to the downside. The Terms of Trade data showed an increase in the total percentage, but this was not good enough for the market players who apparently took the price down and weakened the New Zealand dollar. Although the ‘News Candle’ closes in red at the time of release, it gets immediately taken over by a bullish candle, as this was a ‘demand’ area.

NZD/JPY | Before the announcement:

NZD/JPY | After the announcement:

The above images represent the NZD/JPY currency pair, where we see that the characteristics of the chart are similar to that of the above-discussed pair. Before the news announcement, here too, the market is in a strong downtrend, and the volatility appears to be high on the downside. One thing that is different in this pair is that the price is presently at its lowest point and seems to have made a ‘lower low.’ This means New Zealand is weaker in this pair.

After the news announcement, market crashes and the price drops sharply. The Terms of Trade has a similar impact on the pair, where we see a further increase in volatility to the downside. Again. the weakness does not sustain, and the price shows a large bullish candle after the ‘news candle.’

NZD/CAD  | Before the announcement:

 

NZD/CAD  | After the announcement:

Lastly, we shall discuss the impact on the NZD/CAD currency pair and observe the change in volatility. Here, we see that the market is continuously moving lower before the news announcement indicating a great amount of weakness in the New Zealand dollar. Just before the news release, the price seems to be approaching the ‘demand’ area, which can possibly change the trend for a while by initiating some bullishness in the pair.

The Terms of Trade news announcement gets lukewarm from the reaction where the price initially moves higher little and finally closes forming a ‘Doji’ candlestick pattern. The news release leads to further weakening of the currency where the volatility expands on the downside.

That’s about ‘Terms Of Trade’ and its impact on the Forex market after its news release. If you have any questions, please let us know in the comments below. Good luck!

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