Understanding terms of trade

Recent global events and increased volatility have hit the pockets of many Australians, but Stephen Walters explains why the prolonged slide of Australia’s terms of trade may finally have come to an end.

Let’s be honest: economics can be pretty dull, even for the most dedicated economist. Non-practitioners do not delve into the National Accounts with as much gusto as we do, nor plough through esoteric reports on retail sales, inflation and productivity. Only economists could find fulfilment in the “dismal science”.

But the performance of the economy affects all of us, most particularly via our income, so it’s always helpful to explain convoluted economic concepts in terms that non-economists can readily understand.

Recently retired Reserve Bank of Australia (RBA) governor, Glenn Stevens AC MAICD, was a skilled communicator in this regard, notwithstanding his “dry” persona as a central banker. Stevens once explained Australia’s terms of trade (ToT) in an unusually colourful way, asking members of his audience – this author was one of them – how many imported flat-screen TVs Australia could buy with the proceeds of one shipload of exported iron ore? The governor was highlighting the ToT through the prism of our international purchasing power.

The answer was, that at the height of the commodity price boom in 2011, we could import 10 times as many TVs (nearly 22,000) than we could under “normal” commodity prices that had prevailed for decades. Surging prices for the raw materials we exported, alongside the falling price of many imports, had triggered a profound lift in our standards of living.

In particular, we benefited greatly in the aftermath of the global financial crisis, when world prices for iron ore tripled and prices for coal doubled. These surges followed the massive economic stimulus package in China (Australia’s largest destination for exports), which saw demand for our commodities soar. Supply took some time to catch up, triggering sharply higher prices.

Few of us work for mining companies, but we all benefited from the associated lift in nominal national income, which grew at an average rate of more than 7 per cent in the decade from 2001.

The price of many imported products – like cars and clothing – fell, thanks to the sustained appreciation of the Australian dollar and, in many cases, advances in technology that saw prices of electronic products tumble. For Australians, it couldn’t get much better – higher prices for the goods we sold, lower prices for the goods we bought. Our ToT rose to the highest level since the halcyon days of the 1890s.

The bonanza helped fund the government’s succession of budget surpluses, thanks mainly to higher company tax revenues. In turn, the boom in tax receipts funded what many economists now lament as the explosion of middle class welfare, including the baby bonus and a much expanded first home owners’ grant. There also were many years of personal income tax breaks, including for high income earners.

The problem is, that in the same way that the benefits of higher ToT were shared widely, we all suffer when the index falls. Our ToT has been falling for six years, mainly because of materially lower commodity prices, thanks to an explosion in global supply finally catching up. The reversal of the Australian dollar, too, triggered price rises for many imported products.

The recent decline in the ToT has compressed national income growth, all but reversing the virtuous cycle that had prevailed earlier. In fact, after accounting for population growth and inflation, the drag on national income was even worse. In real per capita terms, national income fell for 15 straight quarters from late 2012 as the ToT slid from those once-in-a-century highs.

Such declines in income normally happen only during recessions and are usually short and sharp. This fall was unusually persistent and did much to turn previously healthy Commonwealth budget surpluses into the yawning deficits we see today. The reversal helps explain why a succession of treasurers has failed in their promise of a return to surplus.

The good news is that the ToT slide may finally be over, thanks in particular to the recent bounce in coal prices. Encouragingly, the index has risen for the last two quarters, which hints that national income also is rising. Commodity prices are fickle, of course, and are exposed to global forces largely beyond our control, but perhaps the extended drain on our living standards is over.