Coming to terms with our terms of trade

Andrew Pegler – 17 June 2011

You’ve heard about Australia’s rising “terms of trade”, but what does it mean?

Well, if you have a vague idea that the terms of trade (let’s call it TOT) is related to exports and the mining boom, you’re right. But that’s not all; it’s also about imports. And finally, most importantly for us, it’s about our real incomes in the global economy.

First the maths (and I’ll keep it short): the TOT is the total price of our exports divided by the total price of our imports. Therefore, the TOT is a ratio.

Here’s a simplified example: if Australia exports $100 worth of products and imports $150 in products, our TOT would be 100/150 = 0.66. Because the ratio is less than 1, it’s considered negative, which means we’re spending more than we’re earning. Long term, money would drain out of the country.

Let’s try again: say we export $100 in products and import $80. Our TOT would be 100/80 = 1.25. That’s a positive ratio, which means we’re earning more from our exports than we’re spending on our imports. The net effect is money coming into the country – which is what we want.

Okay, no more maths. I promise!

So how does Australia’s TOT change over time? Well, we export tonnes of manly stuff like coal, iron ore and liquid gas. And we import quite a bit of nerdy I.T. stuff, you know, computer and communications technology. And here’s the kicker: in recent years, on global markets, coal, iron ore and gas has got more expensive, and I.T. has got cheaper. So our exports are rising in value while our imports are getting cheaper, and, hey presto, up goes our TOT.

Another way of thinking about the TOT is that it describes what quantity of imports we can buy for the sale of a fixed quantity of exports. So, ten years ago a tonne of Aussie coal didn’t buy many Asian-made computers. Nowadays, a tonne of our coal buys a tonne of computers. The TOT has improved in our favour. We can buy more stuff. As a nation, we’re wealthier. Our real incomes are rising.

Finally, what’s all this got to do with the rising Aussie dollar? Nothing. Nada. Zip.

Sure, when the AUD rises, we can buy more imported stuff. But at the same time, our exports are more expensive so we earn less. The exchange rate cancels itself out. Rather, the terms of trade is about the change in value of our exports and imports, not the change in price. It’s all about value, and right now our value is on the up.