Terms of trade

Also called: ToT · Topic: Balance of Payments and Exchange Rates · NCERT: Beyond NCERT

Meaning

Terms of trade (ToT) is the ratio of a country's export prices to its import prices. It tells us how many imports the country can buy with one unit of its exports.

Net barter terms of trade (NBTT) = (Px / Pm) × 100
Px = export price index (an index of the average prices a country gets for its exports).
Pm = import price index (an index of the average prices it pays for its imports).

ToT matters because it shows whether world prices are moving for a country or against it. When ToT worsens, the country must export more just to pay for the same imports. This puts pressure on its trade deficit and its current account deficit.

Explanation

How it works

Improvement (ToT rises): export prices rise faster than import prices, or import prices fall.
One unit of exports now buys more imports.
The country gains from trade without producing anything extra.
Deterioration (ToT falls): import prices rise faster than export prices.
One unit of exports now buys fewer imports.
The country must send out more goods to get the same imports.
Base value = 100. An NBTT above 100 means ToT has improved compared with the base year. Below 100 means it has worsened.

Two main types

Net barter terms of trade (NBTT): compares prices only.
NBTT = (Px / Pm) × 100
Income terms of trade (ITT): adds export volume (how much is exported), not just prices.
ITT = NBTT × export volume index ÷ 100
It measures the import-buying capacity of exports, meaning how many imports the country's total export earnings can pay for.
It rises when either export prices or export volumes rise.
So a country can have a worse NBTT and still have a better ITT, if it sells much more.

Worked example

Step 1: find NBTT.
Export price index = 110. Import price index = 125.
NBTT = (110 / 125) × 100 = 88.
ToT has worsened by 12%. Each unit of exports buys fewer imports.
Step 2: find ITT.
Export volume index = 120.
ITT = 88 × 120 / 100 = 105.6.
Prices moved against the country. But it exported more, so its capacity to import still rose by 5.6%.
Lesson: NBTT shows only the price side. ITT shows whether the country can actually pay for more imports.

What makes ToT rise or fall

Import price shocks: a jump in the price of a key import raises Pm, so ToT worsens.
Crude oil is the main example for India.
World demand for exports: strong demand raises Px, so ToT improves.
Type of goods exported (Prebisch-Singer thesis):
Countries that export mainly primary goods (farm produce and minerals) see their ToT decline over time against countries that export manufactured goods.
Why: prices of primary goods tend to rise more slowly than prices of manufactured goods.
This argument supported import substitution (making goods at home instead of importing them) in India and Latin America from the 1950s to the 1980s.

In India

Oil is the biggest factor: India imports most of its crude oil.
Oil price spike → Pm rises → India's ToT worsens.
The same spike also widens the merchandise trade deficit (imports of goods minus exports of goods) and the current account deficit (the gap when India pays the world more for goods, services and transfers than it receives).
Oil price fall → Pm falls → ToT improves, and the import bill shrinks.
Economic Survey 2019-20: it noted that India's income terms of trade were on a rising trend. A likely reason was that crude prices had not risen faster than India's export prices [2].
Import substitution era: export pessimism based on Prebisch-Singer helped shape India's inward-looking trade policy from the 1950s to the 1980s. That policy ended with the 1991 reforms.

Don't confuse with

Real exchange rate (R = eP*/P): compares overall price levels of two countries, adjusted by the nominal exchange rate. It measures price competitiveness. ToT compares only the prices of the goods a country actually exports and imports, not all goods.
Real effective exchange rate (REER): the trade-weighted nominal rate adjusted for inflation. The RBI publishes it with base 2015-16 = 100 [1]. A REER above 100 is bad for exports (overvaluation). An NBTT above 100 is good (exports buy more imports).
Balance of trade: the value gap between exports and imports, measured in money. ToT is a price ratio. ToT can improve while the trade balance worsens, if volumes move the other way.
Net barter vs income ToT: NBTT uses prices only. ITT multiplies by the export volume index. A fall in NBTT does not always mean a fall in ITT.

Prelims Hooks

NBTT = (Px / Pm) × 100. A value above 100 means ToT improved compared with the base year.
Income ToT = NBTT × export volume index ÷ 100. It measures the import-buying capacity of exports.
Trap: a rise in crude oil prices worsens India's ToT, because India imports most of its crude. A fall in oil prices improves it.
Prebisch-Singer thesis: the ToT of primary-commodity exporters declines over time against exporters of manufactured goods.
Economic Survey 2019-20 noted a rising trend in India's income terms of trade [2].
Trap: an index above 100 is good for ToT but bad for REER (overvaluation). Do not mix up the two readings.

Mains Points

Oil dependence and ToT vulnerability:
India's reliance on imported crude makes its ToT and current account deficit sensitive to oil shocks.
Oil shock → worse ToT → wider current account deficit → pressure on the rupee.
Remedies: energy diversification (renewables, domestic output), strategic oil reserves, and moving exports into higher-value goods. All of these protect the income terms of trade.
Prebisch-Singer and export strategy:
The thesis once justified import substitution in India (1950s to 1980s).
The better lesson today is not to close the economy. It is to move up the value chain, from primary goods to manufactured goods and services, so that export prices do not keep falling behind import prices.
Volume can beat price:
Worse NBTT does not always mean distress. If export volumes grow fast enough, ITT still rises, as the worked example shows.
Policy should therefore boost export competitiveness and scale (productivity, logistics, low inflation to keep the REER in check), not just react to world prices it cannot control.

Related concepts

The long run and real measures: PPP, real exchange rates, terms of trade

Sources

1RBI Bulletin (January 2021), "Revision of NEER and REER Indices"rbi.org.in · tier 1
2Economic Survey 2019-20, Vol. 2, Chapter 6 "External Sector"indiabudget.gov.in · tier 1