Terms of trade magic
10 December 2004
Terms of trade magic
Despite a slight fall in the terms of trade index over the September quarter the index is still hanging around a 15-year high. The terms of trade index (export prices divided by import prices) has a direct bearing on the nation’s purchasing power – it measures the buying power of our exports.
Rob Muldoon used to blame foreigners for undermining our terms of trade and ultimately our standard of living. But blaming foreigners for falls in the terms of trade completely missed the point that New Zealand was exporting goods that foreigners were not particularly interested in buying, and therefore we had to keep discounting the price. To prevent a big blow out in the balance of payments and regular devaluations, the government maintained strict import controls, which not only cocooned local industries, but also quelled competition among importers.
The opening up of the economy from the mid-1980s was intended to force exporters, importers and local industries to become more efficient and competitive. Bluntly, businesses had to produce and sell goods and services that people really wanted, otherwise they would be forced to close. Those firms that survived played a large part in lifting New Zealand’s terms of trade.
Between 1985 and 1990 the terms of trade rose 24.4%, driven as much by falling import prices as by rising export prices. The world price of the goods we imported fell by around 13% over the five years ended March 1991 and has remained relatively stable since. We refer to this as “The Warehouse effect” – an efficient and focused business clearing away lazy importers.
Since 2000 the terms of trade index has edged higher. Indeed, on a five-year moving average basis it is higher now than at any time since the late 1960s. The positive impact this has on the nation’s economic welfare is obvious if we compare growth in GDP with growth in GNDI (gross national disposable income – export receipts are deflated by import rather than export prices). In effect, GNDI is GDP adjusted for the terms of trade. Since June 2000 GNDI has grown on average by 4.2%pa – more than 0.5 percentage points per annum faster than GDP.
What does this mean? Well it tells us that the economy’s purchasing power has been growing significantly faster than production (GDP), and that helps explain why the economy, particularly domestic spending and tax receipts, have exceeded everyone’s expectations. It also tells us that what we produce matters, rather more than simply how much we produce. That message is increasingly relevant given the growing scarcity of labour, pressure on infrastructure, and worries about the environmental impact of increasingly intensive farming.
Probably the best example of what can underpin a rise in the terms of trade is the lamb industry. Since 1990, export lamb prices have increased by around 60% more than the price of all imports. In simple terms, sheep farmers buying a new ute today need to sell around 700 lambs, whereas 15 years ago they would have needed to sell over 2,000 lambs. The transformation of the lamb industry has not been about producing more (as with dairying and forestry). It has been about a whole range of incremental gains in applying research, improved pasture and stock management, new genetics, big productivity advances in the meat processing industry, and most of all steadily tailoring the product to customers’ requirements.
Interestingly, while the gains in the lamb industry have been substantial they have been driven primarily by players in the industry rather than by government initiatives. The success of lamb is not based on the current boom in commodity prices – we send very little lamb to China or the rest of Asia. It mostly goes to high value markets in Europe where economic growth has been lacklustre for several years. Another industry that has contributed significantly to the rise in the terms of trade has been kiwifruit, and again participants rather than the government have driven the gains.
Imagine what spending power the country could enjoy if we could translate some of the lessons from the lamb and kiwifruit industries to forestry, dairying, and better still tourism and education services. Focusing on what the world wants rather than how much we can produce is pretty basic business. There are signs that this lesson is being heeded by some industries, but if we are to add to the gains we have made in the terms of trade, these industries will need to kick on, and other big exporters will need to get their act together.
Andrew Gawith Managing Director Infometrics