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Special Topic: Decomposing New Zealand's Terms of Trade

New Zealand is a small open economy that relies on its external sector as a source of economic growth and development. As a result, New Zealand’s terms of trade, the ratio of export prices to import prices, are a key economic measure. An increase in the terms of trade allows a country to purchase more imports for a given quantity of exports. Changes in the terms of trade can have substantial impacts on the economy as a whole, directly through the impact on export revenues and indirectly through the impact of imported goods and services prices on domestic costs and prices. As a result, the terms of trade are a significant driver of changes in nominal GDP and, consequently, tax revenues.

A recent Treasury Working Paper develops a technique to decompose New Zealand’s terms of trade into the contributions from different components of the export and import baskets. [1] The first part of this special topic examines how New Zealand’s terms of trade have evolved over time. The second part decomposes the terms of trade forecast from the Half Year Update.

New Zealand’s terms of trade have risen substantially since the mid 2000s

New Zealand’s total terms of trade were relatively stable throughout the 1990s and into the early 2000s (Figure 10). Since the mid 2000s, the terms of trade have trended higher although with a much wider cyclical range. Nonetheless, volatility is still much lower than in the 1960s and 1970s. In the March 2014 quarter the terms of trade reached a 41-year high.

Figure 10: Goods terms of trade
Figure 10: Goods terms of  trade   .
Source:  Statistics New Zealand

Decomposition methodology

The decomposition technique described in the paper decomposes the percentage change in the terms of trade into the contributions from different export and import components, e.g. the contribution from dairy exports, the contribution from mineral fuel imports etc. [2] These contributions can then be further split into the contribution owing to a change in deflators (prices) and the contribution from a change in that component’s share of the export or import basket, i.e. the component’s relative weighting in the terms of trade. The decomposition can be undertaken for both adjacent periods (i.e. year-on-year or quarter-on-quarter) and for non-adjacent periods (e.g. the change from 1995 to 2015).

Rising export prices have made the largest positive contribution to the terms of trade over the past two decades...

Figure 11 shows the decomposition of the terms of trade to the year to March 2015. [3] Each column refers to a non-adjacent decomposition of the terms of trade, i.e. 1991 shows the decomposition between 1991 and 2015, 1992 shows the decomposition between 1992 and 2015, and so on. The crosses show the actual change in the terms of trade between the start and end point. The contributions by each component have been partially aggregated to show high-level trends.

Figure 11: Terms of trade decomposition
Figure 11: Terms of trade  decomposition   .
Source:  Statistics New Zealand, the Treasury

Increases in export prices have made the largest contribution to the terms of trade over the past two decades (dark blue bars). Dairy prices have been one of the larger contributors, although there have been price gains across all export components for most of the longer term decompositions.

While export prices have contributed to gains in the terms of trade, the composition of exports has not had a material impact (green bars). In particular, the shift in the weighting of the export basket from meat towards dairy had a relatively neutral impact in terms of contribution to changes in the terms of trade. This is because prices for both have increased over time, so the positive “weighting effect” for dairy (positive price change x increase in weighting) was offset by a negative effect for meat (positive price change x decrease in weighting).

. . .although the changing composition of imports has also made a significant positive contribution

In contrast, the change in the composition of imports has had a material impact (light grey bars). Capital goods and, to a lesser extent, consumer goods have steadily increased as a share of imports in real terms as their prices have generally declined, while intermediate goods and mineral fuels have decreased as their prices increased. The positive compositional effects have acted to partially offset the overall negative contribution to the terms of trade that increasing import prices have made. Most of the adjustment in import composition took place in the period up to the early 2000s.

Overall, the adjustment in import composition appears to be consistent with the aggregation of rational responses by firms and households to changing relative prices. That is, as consumer and capital goods have fallen in price, consumers and firms have demanded relatively more of them, while the economy has become more fuel-efficient in response to higher fuel prices. Since the GFC the compositional effect has faded but import prices have been in overall decline, making a positive contribution to the terms of trade (light blue bars).

Decomposition of the Half Year Update terms of trade forecast

The decomposition technique was initially developed to better understand Treasury’s terms of trade forecast. Figure 12 shows the year-on-year decomposition of the Half Year Update terms of trade forecast.

The large influence dairy prices have on the terms of trade in recent years is apparent in the chart. In the year to March 2015, dairy prices reduced the terms of trade by 3.6 percentage points (pps). A similar negative contribution of 3.0 pps is expected in the March 2016 year. As dairy prices recover, they are expected to make a positive contribution to the terms of trade in the 2017, 2018 and 2019 March years. Export prices excluding dairy are expected to make positive contributions throughout the forecast period, particularly non-commodity and export services. The forecast depreciation of the New Zealand dollar in 2016 and 2017 partly drives these positive contributions.

Figure 12: Terms of trade forecast decomposition (March years)
Figure 12: Terms of trade forecast decomposition (March years)   .
Source:  Statistics New Zealand, the Treasury

Falling mineral fuel prices (chiefly as a result of falling crude oil prices) provided a sizeable offset to falling dairy prices in the March 2015 year (+1.8 pps) and are forecast to continue to do so in the March 2016 year (+2.6 pps). Import prices more generally made positive contributions to the terms of trade in the March 2015 year. However, import prices excluding oil are expected to make negative contributions to the terms of trade over 2016 and 2017, partly as a result of the depreciating dollar. [4]

The lower terms of trade forecast over 2016 and 2017 March years are a significant driver of the slower growth in nominal GDP forecast in the Half Year Update, and consequently slower growth in tax revenues.

Notes

  • [1] Mellor, P (2015) "Decomposing New Zealand’s Terms of Trade." New Zealand Treasury Working Paper No. 15/16, December.
  • [2] For consistency with the Treasury forecasts, the SNA groupings are slightly aggregated. The Treasury export components are dairy, meat, forestry, other goods, non-commodities and export services. The import components are consumer goods, intermediate goods, capital goods, mineral fuels and import services.
  • [3] The historical analysis in this special topic uses data from the March 2015 quarter release - there have been data revisions in the two releases since, although these do not alter the analysis significantly.
  • [4] The net effect of the lower exchange rate on the terms of trade is neutral - the positive impact (from increased export prices) is offset by the negative impact (from increased import prices).
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