What is Terms of Trade?

How do you assess the economic health of a country? To get a full picture, you would need to look at a few different indexes. One helpful indicator is a nation’s terms of trade (TOT). This metric shows whether a country’s current trading practices are growing or damaging its economy. Not sure how to calculate and interpret this important index? Here’s a closer look.

A country’s terms of trade is the ratio of its index of export prices to its index of import prices.

If a country makes more money on exports (things it sells abroad) than it does on imports (things it purchases from abroad), it has a TOT of more than 100%. This is usually an indicator that the economy is growing.

On the other hand, if a country spends more on imports than it makes on exports, its TOT will be less than 100%. That might be a sign that the economy is being damaged.

Think of it this way. Suppose that you make paintings and sell them online. If you typically spend $100 on supplies (your imports) and make $500 on the paintings (your exports) each month, that’s good for your bank account. If you were a country, you’d have a terms of trade over 100%.

However, if you spend $100 on supplies and only make $75 on paintings per month, you’re losing money. This is obviously bad for your finances, and if you were a country, your terms of trade would be under 100%.

A country’s terms of trade is a useful metric that is easy to calculate. Here’s the equation:

Terms of trade (TOT) = (Price index of total exports)/(Price index of total imports) x 100

Going back to the above example, if you spend $100 and make $500 per month, your terms of trade for that month would be this:

($500)/($100) x 100 = 500%

And if you spend $100 and make $75 each month, it would be this:

Depending on what you want to track, you may want to use one of a few different terms of trade calculations:

• Net barter/commodity terms of trade
• Gross barter terms of trade
• Income terms of trade
• Single factorial terms of trade
• Double factorial terms of trade

Here’s what you can expect from each one.

This is the calculation most people are referring to when they mention terms of trade. It helps track a country’s overall export earnings vs. import earnings. Its calculation looks like this:

(Price index of total exports)/(Price index of total imports) x 100

This one isn’t used often. It shows you the ratio of physical quantities of imports and exports as opposed to prices. The equation looks like this:

(Aggregate quantity of imports/Aggregate quantity of exports) x 100

The income terms of trade will show whether a country’s ability to purchase imports (from its export earnings) is increasing or decreasing. The equation looks like this:

(Export price index)/(Import price index) x Index of volume of exports

This TOT calculation will show you how much purchasing power a country’s exports have. It shows you what volume of imports can be paid for with export earnings. The calculation looks like this:

(Export price index)/(Import price index) x Productivity index in export sector

This TOT isn’t often measured. It shows you the change in productivity of both importing and exporting countries. The calculation looks like this:

(Export price index)/(Import price index) x (Export productivity index)/(Import productivity index) x 100

There’s no single factor that changes the terms of trade. Here are a few of the factors that have the power to shape it.

As you likely already know, increasing demand for a product often raises the price. This factor is best illustrated by an example. Let’s say the U.S. exports corn, and Canada exports wheat. If Canada’s demand for corn increases, the price of corn will rise relative to wheat. The net or commodity terms of trade will become more favorable to the U.S. If U.S. demand for wheat increases, the net or commodity terms of trade will become more favorable to Canada.

This factor is common sense. Using the example above, if the people of the U.S. start to tire of Canada’s wheat, they’ll buy less of it. That, in turn, decreases Canada’s commodity terms of trade.

Sometimes, a country may impose a tariff on certain imported goods. When this happens, the TOT for those imported goods tends to shift in favor of the importer. For the exporter, the commodity terms of trade decline as the tariff-imposing importer generally purchases less.

Exchange rates constantly fluctuate, and significant changes in importer and exporter currencies can shift the TOT. For example, if an exporting country’s currency has appreciated significantly, its exports become more expensive. In some cases, buyers of those exports can be priced out.

Like exchange rates, inflation can also have a major impact on TOT. If a country is experiencing significant inflation, the cost of producing export goods may rise. If another country without much inflation makes that same commodity, importers may be able to purchase it from that country for much less. As a result, commodity TOT for the inflation-impacted country will likely decrease.

Suppose that you want to find out the commodity terms of trade for country X. For the sake of simplicity, say the export price index is five, and the import price index is four. You can plug these numbers into the terms of trade formula:

Because the terms of trade is over 100%, the terms of trade is currently favorable to country X.

So how do terms of trade impact you, the investor? If you invest in commodities, you know that changes in the prices of commodities have a direct impact on your returns.

For example, if the commodity terms of trade for corn exports in the United States increases, the export price index increases (at least relative to the import price index). If you’ve invested in corn commodities and the price of corn goes up, you’ll likely see greater returns.

On the flip side, if the commodity terms of trade for corn decreases, the export price index probably will as well. As a result, you’ll see lesser returns.

Great investors have honed their ability to spot trends. And when you know how to track and interpret terms of trade for a given country, you’ll be better equipped to predict how commodity prices may start to rise and fall.

This skill is only one part of the picture. If you want to improve as an investor, check out the many free resources Benzinga offers.