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Terms of trade and current a/c balance in BD

Published: Tuesday, Mar 29, 2016

FE-PRI EAU

Posted : 29 Mar, 2016 00:00:00

 

 

Terms of trade and current a/c balance in BD

Muhammad Shafiullah and Faridul Islam

The concept of terms of trade is important for an open economy. This is so because it can be seen as an indicator of the health for an open economy. So, a relevant question is: what is terms of trade? To put it simply, a nation's terms of trade refers to the relative price of exports to its imports in the context of a country's trade. However, other measures of terms of trade have also been offered -- although the more often used one -- is the ratio of price of import to export. Changes in terms of trade have major ramifications for the welfare of the citizens or even those in other economies.

THE RELATIONSHIP BETWEEN TERMS OF TRADE AND CURRENT ACCOUNT BALANCE: A PRIMER: A case in point is, arguably, the link between the devaluation of Thai baht and the subsequent Asian financial crisis of 1997. Devaluation raises its import price and allows exports to become more competitive, under certain circumstances. The policy tool when carefully applied, can help to improve an ongoing current account balance situation, provided some conditions are met (e.g. Marshall Lerner conditions).

The Marshall-Lerner condition refers to trade responding proportionally to changes in the real exchange rate.Specifically, the tool is used by a country only when it suffers from chronic deficit in its current account balance. Consider for example, if a country's import prices increase, while the value of its exports stays the same, the country's terms of trade are said to have deteriorated. As a nation experiences deteriorating terms of trade, it implies that expenditures on imports are growing faster than income from exports, resulting in a growing trade deficit.

The effects on the current account balance, and, importantly, the link between it terms of trade movements have been an area of curiosity for both policy makers and academics interested in small open economies, especially the developing ones. A careful examination of the current account balance for an economy at any point in time helps to gauge the balance of trade, net primary income or factor income (earnings on foreign investment minus payments made to foreign investors) and net cash transfers over a given period of time.

The link between current account balance and the terms of trade was first documented by Arnold Harberger; and by Svend Laursen and Lloyd Metzler in the 1950's, independently, and has since been named as the HLM effect, after the first initials of the authors. In terms of the effect, a worsening in the terms of trade raises real expenditure out of a given level of income, reduces saving and the level of investment, eventually leads to a deterioration in the current account balance. Conversely, an increase in the terms of trade leads to an increase in domestic demand and consumption, but by less than proportion; resulting in increased savings, and an improvement in the current account balance, all else equal.

For the developing countries in general, and for the smaller economies in particular, shocks to the terms of trade can cause severe disruption in economic activities; and be a source of major fluctuation in the current account balance which can affect the overall macro economy. Many of these nations are often characterized by export earnings dominated by a narrow range of primary commodities. Since the prices of these primary commodities are subject to considerable variation in the world market, the terms of trade fluctuations in developing countries tend to be more volatile in comparison to developed ones -- a possibility that makes the topic of particular significance for the academicians and policymakers. Bangladesh's increased interest in 'openness' only adds to the importance of the issue.

Terms of trade and current a/c balance in BD

The postulated effect of terms of trade came under challenge from the academia, notably, renowned development economists such as, Jeffrey Sachs in 1981, inter alia. He documented that a transitory change in the terms of trade brings a positive change in the current account balance, while a permanent change thereto can produce an ambiguous effect. Others tried to expound the impacts of unanticipated terms of trade on current account balance using theoretical models such as optimizing framework, intergenerational substitution model, elasticity approach, representative-individual intertemporal model, dynamic small open economy model, etc.

Many of these theoretical studies concluded that an exogenous terms of trade shock affects current account balance of an economy, but at the same time is subject to certain caveats including the behaviour of investment, import of capital-intensive goods etc. Studies that employed empirical models used various econometric and statistical tools. The results however, have offered mixed evidence, citing sensitivity to data and estimation techniques used, country studied etc.

THE EMERGING SCENARIO IN BANGLADESH: The question we are faced with is: how does Bangladesh fare in this regard? Figure 1 plots Bangladesh's current account balance and terms of trade during the period, from fiscal year (FY) 2000 to FY 2015. It can be seen that Bangladesh's current account balance and terms of trade did not start moving together until the late 2000s. In the early 2000s, Bangladesh's terms of trade was virtually flat declining only slowly until the onset of the Global Financial Crisis (GFC, hereafter) in the late first decade of the 2000s. Bangladesh also faced a commodity shock shortly before the onset of the GFC, and a combination of such a shock and the GFC contributed to a sharp plunge in the terms of trade in 2008. After the onset of the GFC, the terms of trade began to fluctuate only slightly, still moving up and down from time to time.

Since the 2000s, Bangladesh's current account balance has been consistently positive for much of the time, but fluctuating quite a bit throughout the period. A careful examination of the trend reveals that although mostly in the positive zone in the early and late 2000s, Bangladesh's current account balance fluctuated several times into the negative territory. The positive current balance generally depicts a slowdown in investment in Bangladesh which imports much of the capital required for investment. The housing market bubble, and its subsequent burst clearly drew a fault line for the global economies. These developments made it abundantly clear that something was not right. The readymade garments industry in Bangladesh, a major foreign exchange earner, suffered significantly which affected the export earnings as a result of the onset of the GFC.

Bangladesh's saving grace came from the 'Walmart effect', as spending on basic garments, the staple of the country's exports, remained steady or even increased in most of the country's traditional export markets. From this point forward, however, the current account balance began to move sharply towards the negative territory; and by 2011 it was negative for a year staying positive for the next two years and went negative again.

This last bout with current account deficit might have been due to political instability and the uncertainty about the direction of world order. The jitters in the world market are still for real. No one predicts that the situation will be much better. Instead most agree that the problem will continue to persist, with no end in sight anytime soon. For Bangladesh, the situation had the appearance of a double jeopardy; particularly the uncertainty with migrant labour remittances as employment in an already volatile environment, complicating the traditional markets in the Middle East. The expectations of a brighter economic and political outlook seem like a far cry. A resurgent labour market in East Asia such as Malaysia, Singapore, and Korea etc., might have been dashed away.

A recent working paper, presented at a Western Economic Association International Conference in Singapore earlier this year, found Bangladesh's terms of trade to have a statistically significant long-run causal effect on its current account balance. These results imply that current account balance of Bangladesh is sensitive to the terms of trade movements. This may be due, in part, to the pioneering role Bangladesh played in the region in initiating economic liberalisation, as well as emphasis on export-orientation and trade openness. The fact that Bangladesh, thus far, has been successfully prosecuting long-term stable macroeconomic policies might have contributed to this notable accomplishment, albeit for a relatively shorter period of time.

Bangladesh's terms of trade has been on a persistently declining trend since 2000, for most part of it. While this might be short lived as one would hope for; it, nonetheless, raises concern of much serious nature. The appearance of a long-term decline of the country's terms of trade bears resemblance to another well-known macroeconomic, not so happy trend, popularly known as the Prebisch-Singer hypothesis. The Prebisch-Singer hypothesis, in brief, argues that the price of primary commodities declines relative to the price of manufactured goods over the long term, which causes the terms of trade of primary-product-based economies to deteriorate.

Evidently, much of the twentieth century, has witnessed that the less developed countries have endured deterioration in the terms of trade relative to more advanced nations. Several explanations have been adduced to help us to gain good understanding of the reasons behind this development, including the 'unequal exchange' that happened between rich and poor countries. Some of the more recent research findings have re-examined data which clearly showed more favourable trade terms for a large number of countries in the developing world. These analyses consider the importance of trade composition, productive capacity, labour power, foreign capital, factor endowments, and macroeconomic conditions and even the relative bargaining power that these countries possess during exchange, and how they affect the country's net barter terms of trade. Results suggest that changes in the terms of trade can be attributed to several factors, most notably, the role of foreign capital penetration. The latter almost invariably causes deteriorating terms of trade via its impact on labour conditions, while countries with better negotiating position in the trade network tend to experience more favourable trade terms.

The foregoing discussion can help one to better assess the position of Bangladesh under the current context. Understandably, the main exports Bangladesh -- Ready-Made Garments or RMGs -- are 'manufactured' commodities. In the same vein, their value addition as well as export prices are low (and possibly declining) relative to high value added capital and consumer goods that contribute a large fraction of the nation's imports.

In addition, the RMG export prices are set from outside where Bangladesh has little, if any, influence to bargain. This makes the sector susceptible to price changes resulting from changes in economic activities in its major export destinations, especially in North America and Europe. This might help to explain, in part, the reason behind a sustained decline in its terms of trade in Bangladesh. In addition, it also points to what the future might hold for Bangladesh's terms of trade.

CONCLUDING REMARKS: The nexus between terms of trade and current account is a virtually unexplored issue in the context of Bangladesh, which makes the policy makers and researchers less familiar on what to expect. For a small economy like Bangladesh, terms of trade shocks can have decimating effects on its current account balance. While Bangladesh export basket is not composed mainly of primary commodities, its import basket includes many primary commodities. Its biggest export earner, RMG, is low-value added manufactured goods, which are also vulnerable to price shocks in the international markets. As such, terms of trade shocks and their possible impacts should be an area of concern to the Bangladesh policy makers. Perhaps, they need to observe the emerging scenario to gain better understanding of the underlying dynamics in an effort to find ways to mitigate the harmful effects on the country's current account balance.

Bangladesh foreign exchange earnings are characterized by export of goods and some services, but more importantly, a sizeable part comes through by remittances. In view of this, it is important for the nation to put significant emphasis not only on investment, as we conventionally understand, to lift domestic output, boost export and thus improve trade balance, but also to invest on human capital. This will among others add to both skilled and semi-skilled workers. All of them taken together will help to improve the current account balance both in the short and long run.

Some studies indicate that real devaluations improve trade balance. Although Bangladesh operates under 'managed' floating exchange rate system, the country might be able to avoid a major shock-internal and external-so long as a well-managed floating exchange rate policy is at work and actively followed. Bangladesh can and should learn replicable useful lessons from the experiences of its relatively stronger neighbours such as India and Sri Lanka.

[Professor Faridul Islam is Chair, and Professor, Department of Economics, Morgan State University, USA. He can be reached at faridul.islam@morgan.edu. Dr. Muhammad Shafiullah is a Senior Economist at Policy Research Institute of Bangladesh. He can be reached at mshafiullah@pri-bd.org.]

http://print.thefinancialexpress-bd.com/2016/03/29/137620

 

 

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