Terms of Trade (ToT)
What is Terms of Trade (ToT)?
Terms of trade (ToT) compare a nation's export prices with its import prices and indicate how much a country can purchase with its exports. It simply indicates the purchasing power of a nation's exports in international markets. If India's export prices increase at a higher rate than its import prices, then its terms of trade increase, indicating that it can purchase more imports for the same quantity of exports. Think of it as receiving greater value for what you export overseas.
How Terms of Trade is Calculated?
Terms of trade are determined as:
Terms of Trade = (Index of Export Prices ÷ Index of Import Prices) × 100
- Export Prices: The mean price of products and services exported to foreign nations (e.g., India's software services or textiles).
- Import Prices: The average price of goods and services purchased from overseas (e.g., crude oil or electronics).
For instance, if India's export price index is 120 and its import price index is 100, the ToT is (120 ÷ 100) × 100 = 120. A ToT of more than 100 means favorable terms, while less than 100 means unfavorable terms.
Why It Matters?
Terms of trade assist in measuring the economic well-being and trade efficiency of a nation. For India, which is dependent on exports such as IT services and pharmaceuticals and imports such as oil, positive ToT can increase national income and make the rupee stronger. Policymakers, companies, and economists utilize ToT to measure trade competitiveness and make economic strategy decisions.
Examples in Practice
- Pharmaceutical Exports: When India's exports of generic medicines increase in terms of price from ₹100 crore to ₹120 crore because of demand abroad, but prices of imported chemicals remain at ₹80 crore, ToT increases so that India can purchase more imports using revenues from drugs.
- Oil Imports: If world oil prices rise, increasing India's import expense to ₹250 crore from ₹200 crore, but prices of textile exports stay at ₹150 crore, the ToT deteriorates, lowering India's purchasing power.
- IT Services: If Indian software services export prices rise from ₹500 crore to ₹600 crore while imported technology hardware prices stay at ₹300 crore, the ToT increases, favoring the economy.
Key Insights
- Enhancing ToT: Increased export prices or decreased import prices imply a nation can import more for every unit of export, increasing wealth.
- Slumping ToT: Increased import prices or decreasing export prices lower purchasing power, tightening economies such as India's based on oil imports.
- Volatility: ToT may fluctuate as a result of world commodity prices, exchange rates, or shifts in demand, affecting India's trade balance.
Benefits of Favorable Terms of Trade
- More Wealth: India can purchase more imports, enhancing living standards or industrial inputs.
- Support to Trade Balance: Improved ToT can counter trade deficits, a major issue for India due to its dependence on oil imports.
- Economic Stability: Bolsters foreign exchange reserves, supporting the rupee value.
Challenges and Risks
- Global Dependence: Externally driven factors such as price increases in oil or demand for exports from India are difficult to control and impact ToT.
- Sector Imbalance: India's ToT could be adversely affected if heavy-importing industries (like energy) overshadow export surpluses in manufacturing or services.
- Trade Policy Risks: Excessive dependence on positive ToT breeds complacency, ignoring diversification of exports or domestic output.
