Past, Present and Future Developments in New Zealand's Terms of Trade

Borkin, Philip Working Paper Past, Present and Future Developments in New Zealand's Terms of Trade New Zealand Treasury Working Paper, No. 06/09 Provided in Cooperation with: The Treasury, New Zealand Government Suggested Citation: Borkin, Philip (2006) : Past, Present and Future Developments in New Zealand's Terms of Trade, New Zealand Treasury Working Paper, No. 06/09, New Zealand Government, The Treasury, Wellington This Version is available at: https://hdl.handle.net/10419/205585 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Past, Present and Future Developments in New Zealand’s Terms of Trade Philip Borkin N EW Z EALAND T REASURY W ORKING P APER 06/09 J ULY 2006 WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade i NZ TREASURY WORKING PAPER 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade MONTH / YEAR July 2006 AUTHOR Philip Borkin New Zealand Treasury PO Box 3724 Wellington New Zealand Email Telephone Fax [email protected] 04 917 6166 04 499 0992 ACKNOWLEDGEMENTS I would like to gratefully acknowledge the help of Bob Buckle for comments on an earlier draft. I would also like to thank Arthur Grimes, John Ballingall, Craig Beaumont, Patrick Conway, Khoon Goh, Richard Downing, and Alex Harrington for their helpful comments as well as Kam Szeto and Dean Hyslop for their help with some empirical tests. Finally I would like to thank Daniel Lawrence and Rob Davison for their help with data. Of course all remaining errors are my own. NZ TREASURY New Zealand Treasury PO Box 3724 Wellington 6008 NEW ZEALAND Email Telephone Website [email protected] 64-4-472 2733 www.treasury.govt.nz DISCLAIMER The views, opinions, findings, and conclusions or recommendations expressed in this Working Paper are strictly those of the author(s). They do not necessarily reflect the views of the New Zealand Treasury. The Treasury takes no responsibility for any errors or omissions in, or for the correctness of, the information contained in these working papers. The paper is presented not as policy, but with a view to inform and stimulate wider debate. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade ii Abstract This paper looks at the importance of the terms of trade for the New Zealand economy by examining the impact of changes in the trend and volatility of the terms of trade on economic growth. It is found that the volatility in the terms of trade has had a negative impact on New Zealand’s economic growth between 1950 and 2005. However, it is found that rather than the level of the terms of trade having an impact on growth, it is the level of export prices that have had a significant positive effect with the level of import prices having an insignificant impact. This paper also examines the historical patterns in the trend and volatility to see if and why they have changed over time. As New Zealand is largely an exporter of primary commodities and importer of manufactures, the Prebisch- Singer hypothesis suggests that its terms of trade should have declined over time. However, this paper finds that the terms of trade has not declined and in fact, is showing an increasing trend since 1974. It is also found that the volatility in the terms of trade has declined over time. Using this evidence as well as other issues such as world trade reform and China, this paper draws conclusions as to future movements of New Zealand’s terms of trade as well as any possible economic growth implications. JEL CLASSIFICATION E30 General; F10 General; F41 Open economy macroeconomics; F43 Economic growth of open economies; KEYWORDS Terms of trade; Commodity Prices; New Zealand; Economic Growth; Prebisch-Singer Hypothesis WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade iii Table of Contents Abstract..............................................................................................................................ii Table of Contents .............................................................................................................iii List of Tables.....................................................................................................................iii List of Figures...................................................................................................................iv 1 Introduction ..............................................................................................................1 2 Why are the terms of trade important? ..................................................................3 2.1 Terms of trade trends and economic growth..................................................................3 2.2 Terms of trade volatility and economic growth...............................................................5 2.3 New Zealand evidence...................................................................................................6 3 Trends and volatility in New Zealand’s terms of trade .......................................10 3.1 Long-run trend ..............................................................................................................10 3.2 Volatility .......................................................................................................................16 4 Why have the trend and volatility changed? .......................................................19 4.1 Compositional change in New Zealand’s goods exports .............................................19 4.2 Compositional change in New Zealand’s goods imports .............................................24 4.3 Endogenous nature of New Zealand’s terms of trade..................................................25 4.4 The impact of China......................................................................................................25 5 Factors likely to influence the terms of trade in the future................................26 5.1 Changes in the trend and volatility ...............................................................................26 5.2 China .......................................................................................................................27 5.3 Other issues..................................................................................................................29 5.4 What are the growth impacts?......................................................................................30 6 Conclusion..............................................................................................................31 Appendix 1 – Data Description and Source..................................................................33 Appendix 2 – Decomposing New Zealand’s economic growth...................................34 References .......................................................................................................................36 List of Tables Table 1 – Results from the Estimation of Equations (1) and (2).........................................................8 Table 2 – New Zealand’s Merchandise Exports Composition..........................................................11 Table 3 – New Zealand’s Merchandise Imports Composition ..........................................................11 Table 4 – Unit Root Tests for Log Goods Terms of Trade................................................................12 Table 5 – Trend in Log Goods Terms of Trade.................................................................................13 Table 6 – Trend in Log Goods Terms of Trade (Allowing for Persistence) ......................................13 Table 7 – Measures of Volatility in New Zealand’s Log Goods Terms of Trade...............................16 Table 8 – Results of Bai and Perron (1998) Test for Structural Break in Volatility of Terms of Trade ......................................................................................................................................17 Table 9 – Decomposing the Log Terms of Trade Variance..............................................................18 Appendix Table 1 – Data Sources for Section 3...............................................................................33 Appendix Table 2– Decomposition of GDP Growth using Fox et al (2003) Alternative Methodology............................................................................................................................35 WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade iv List of Figures Figure 1 – New Zealand’s Merchandise Terms of Trade....................................................................1 Figure 2 – Terms of Trade Effect on Purchasing Power.....................................................................3 Figure 3 – Actual and Predicted GDP Growth....................................................................................9 Figure 4 – Relative Commodity Prices and New Zealand’s Terms of Trade....................................14 Figure 5 – Relative Export and Import Prices ...................................................................................15 Figure 6 – Goods Terms of Trade Volatility ......................................................................................17 Figure 7 – New Zealand’s Good Export Composition (5 year moving average) ..............................19 Figure 8 – Goods Terms of Trade Using Actual, 1960 and 1980 Export Shares.............................21 Figure 9 – Destination of New Zealand’s Good Exports (5 year moving average)...........................22 Figure 10 – New Zealand’s Good Exports by Level of Processing...................................................23 Figure 11 – Export Lamb Product Mix...............................................................................................24 Figure 12 – Source of New Zealand’s Good Imports........................................................................24 Figure 13 – Proportion of GDP by Economic Activity for China........................................................27 WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 1 Past, Present and Future Developments in New Zealand’s Terms of Trade 1 Introduction New Zealand is a small economy dependent on its external sector as a major source of economic growth and development. Although its trade to GDP ratio is not high by OECD standards, at 60%, it does leave it prone to movements in the relative prices of internationally traded goods. The terms of trade, or the ratio of export prices to import prices, is a measure of these relative prices and can have substantial welfare effects on the economy. Figure 1 – New Zealand’s Merchandise Terms of Trade 500 700 900 1100 1300 1500 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Index (2000 = 1000) Sources: NZIER, Statistics New Zealand Figure 1 above shows New Zealand’s merchandise terms of trade since 1900.1 It is clear that there have been periods over this time when the terms of trade has changed considerably from both a trend and volatility perspective. This paper attempts to answer three questions: how the trend and volatility in the terms of trade impact on New Zealand’s economic growth; whether or not the trends and volatility of the terms of trade have changed over time; and what factors are likely to influence the trends and volatility of the terms of trade in the future. 1 This paper uses the goods terms of trade rather than the goods and services terms of trade due to better data availability. Statistics New Zealand has data on the SNA services terms of trade back to 1988. It is very highly correlated with the New Zealand TWI exchange rate (correlation = 0.95). WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 2 This paper adds to the ever growing literature on the drivers of New Zealand’s economic growth by examining how the terms of trade affects the economy as well as what factors will influence the terms of trade in the future. As New Zealand is a small country, the terms of trade can be thought of as predominantly exogenous. Therefore rather than policy makers targeting the terms of trade as a policy instrument, it is more appropriate for them to have an understanding of how the terms of trade affects the economy and hence have an understanding of the policy implications of terms of trade movements. Policy makers, not only in New Zealand, but other countries are increasingly thinking of the terms of trade in this way.2 The debate in the literature on the macroeconomic effects of trends in the terms of trade is mixed. Views vary from the terms of trade having a positive effect to a negative effect on economic growth, with the former being the most common. This is because a rise in the terms of trade implies a rise in a country’s real domestic income. An increase in export prices relative to import prices allows a larger volume of imports to be purchased for a given volume of exports, resulting in an increase in purchasing power. The terms of trade can also be thought of as a return on investment and it is through this investment channel and the real domestic income channel mentioned above that the macroeconomic effects of the terms of trade are commonly studied. However, there is one area of the literature that concludes that increases in the terms of trade have a negative effect on a country’s growth performance. One of the reasons proposed for this is known as the ‘resource curse’. This is discussed further below. The literature is much more united in its belief about the economic effects of volatility in the terms of trade. Increased volatility is found to have a negative impact on economic growth. Section two examines this literature as well as the literature looking at the macroeconomic impacts of trends in the terms of trade. In order to put it into a New Zealand context, an empirical analysis based on work by Grimes (2006) is tested in this section to see how economic growth in New Zealand is affected by trends and volatility in the terms of trade. Section three looks at the historical trends and volatility of New Zealand’s terms of trade. For the majority of New Zealand’s economic history, primary commodities have dominated its goods exports while it has largely imported manufactured goods. According to the Prebisch-Singer hypothesis, which states that over time primary commodity prices decline relative to manufactures prices, New Zealand should have experienced a secular trend decline in its terms of trade. This section examines this hypothesis to assess whether it holds for New Zealand using the methodology of Gillitzer and Kearns (2005). They performed a similar study for Australia and found that its terms of trade have declined over time, albeit very gradually. The volatility of the terms of trade is also examined in this section to assess if it has changed over time. Section four examines some developments in New Zealand export and import prices and how they have affected the trend and volatility of the terms of trade. Section five uses the analysis of the trends and volatility of the previous sections and considers other issues such as the emergence of China in the global market and potential trade reforms to assess possible future movements in New Zealand’s terms of trade. The final section concludes as well as looks at policy implications and areas of future research. 2 For example, Henry (2006) http://www.treasury.gov.au/contentitem.asp?NavId=008&ContentID=1112. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 3 2 Why are the terms of trade important? 2.1 Terms of trade trends and economic growth As movements in the terms of trade reflect changes in relative prices, it is often unclear how these movements affect the real economy. Although this has been debated extensively in the literature to date, there is still no consensus view about how trends in the terms of trade impact on economic growth. The most common view is that the terms of trade has a positive impact on economic growth. An increase in export prices relative to import prices allows a larger volume of imports to be purchased with a given volume of exports. The implied increase in the real purchasing power of domestic production is equivalent to a transfer of income from the rest of the world and can have large impacts on consumption, savings and investment. The terms of trade can also be thought of as a rate of return on investment and therefore a secular improvement in the terms of trade leads to an increase in investment and hence economic growth. A graphical illustration of the income effect of a movement in the terms of trade is shown in Figure 2. Real gross domestic income (RGDI) measures the purchasing power of the total income generated by domestic production. The difference between real GDP and RGDI is defined as the terms of trade effect. The appreciation of the terms of trade over 2004 led to a boost in real incomes and this is shown by RGDI exceeding real GDP over 2004 and 2005. Figure 2 – Terms of Trade Effect on Purchasing Power 80 90 100 110 120 130 140 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 $ billion Real GDP Real Gross Domestic Income Source: Statistics New Zealand Although the changes to real incomes from terms of trade movements can be seen in Figure 2, the total economy-wide impacts of terms of trade movements are hard to quantify. Changes in the terms of trade can have different macroeconomic impacts depending on the composition of the relative price movements. If a fall (rise) in the terms of trade is due to a decrease (increase) in export prices, then this will initially impact on exporters before indirectly affecting households. However, if a fall (rise) in the terms of trade is a result of an increase (decrease) in import prices (for example, oil prices), this is likely to affect households and businesses more directly and the macroeconomic shock will be different. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 10 variability. That is, annual GDP growth can be explained by lags of itself plus the level of real export prices and real import price volatility. The next section looks in more detail at how the level and volatility of New Zealand’s export and import prices have changed over time. 3 Trends and volatility in New Zealand’s terms of trade The previous section described the current views in the literature surrounding the impact of terms of trade trends and volatility on economic growth and briefly looked at it from a New Zealand context. This section looks at the historical trend and volatility in New Zealand terms of trade to see if they have changed over time. It follows very closely the methodology used by Gillitzer and Kearns (2005) in their study of long-run trends and volatility in Australia’s terms of trade. The description and sources of the data for this section are explained in Appendix 1. 3.1 Long-run trend 3.1.1 Has New Zealand’s terms of trade declined over time? Tables 2 and 3 below display the composition of New Zealand’s merchandise trade over the past ten years. It is clear that New Zealand’s exports are dominated by primary commodities while its imports are dominated by manufactured goods. For this reason, the Prebisch-Singer hypothesis implies that the terms of trade should have declined over history and should continue to decline. This would have implications for the economy, some of which were discussed in the previous section. There have been some significant events in New Zealand’s economic history that have had an impact on the terms of trade. One of these events was when the UK formally joined the European Economic Community (EEC) in 1973. At the time the UK was New Zealand’s biggest export destination taking 72% of lamb exports, 73% of butter exports, 66% of cheese exports and approximately 20% of wool exports.7 The UK joining the EEC had the effect of dramatically reducing the demand for New Zealand products in the UK and led to a significant reduction in export prices. It required New Zealand to identify new markets for its primary exports as well as develop new merchandise in order to remain competitive overseas. Other events at the time which may have affected the terms of trade were the commodity price boom of the early 1970s, followed by the first oil shock in late 1973. 7 These figures were taken from Dalziel and Lattimore (2004). WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 11 Table 2 – New Zealand’s Merchandise Exports Composition Exported Product 1995 2000 2005 year ended March 31 value $m % of total value $m % of total value $m % of total Non-commodity manufactures 4,345 20.8% 5,528 22.5% 8,434 27.1% Dairy, casein and caseinates 3,337 15.9% 4,459 18.1% 5,678 18.3% Meat and edible offal 2,689 12.9% 3,198 13.0% 4,688 15.1% Forestry products 2,515 12.0% 2,942 12.0% 2,957 9.5% Fruit 764 3.6% 1,059 4.3% 1,355 4.4% Seafood products 1,084 5.2% 1,183 4.8% 1,126 3.6% Aluminium and aluminium articles 826 3.9% 1,013 4.1% 1,071 3.4% Wool 1,299 6.2% 760 3.1% 698 2.2% Other goods exports 4,065 19.4% 4,473 18.2% 5,082 16.3% Total 20,923 100.0% 24,615 100.0% 31,088 100.0% Source: Statistics New Zealand Table 3 – New Zealand’s Merchandise Imports Composition Imported Product 1995 2000 2005 year ended March 31 (VFD) value $m % of total value $m % of total value $m % of total Minerals, chemicals and plastics 4,322 22.6% 6,148 23.4% 8,611 26.0% Machinery and mechanical appliances 5,092 26.6% 6,238 23.8% 7,865 23.7% Vehicles and aircraft 3,267 17.1% 5,171 19.7% 5,910 17.8% Other manufactures 1,528 8.0% 2,124 8.1% 2,488 7.5% Metals and articles of metal 1,233 6.4% 1,489 5.7% 1,946 5.9% Textiles and textile articles 1,165 6.1% 1,451 5.5% 1,554 4.7% Other goods imports 2,529 13.2% 3,604 13.7% 4,764 14.4% Total 19,136 100.0% 26,226 100.0% 33,139 100.0% Source: Statistics New Zealand Another influential period was the Korean War in 1950. This saw the demand for wool increase dramatically with the price of wool rising by over 150% in two years. The overall impact of this wool price shock saw the goods terms of trade reach a record high in 1951 before falling once the war was over. In order to test whether any of these periods had a large influence on the trend or level in New Zealand’s terms of trade, the Andrews and Ploberger (1994) test for a structural break was used.8 However, it yielded inconclusive results and found no evidence of a structural break in the terms of trade (expressed in logarithms) for annual data from 1900 to 2005.9 8 I thank Kam Szeto for performing this test for me. 9 However, using quarterly data from 1950-2005, the test found evidence of breaks in the trend as well as other coefficients. The results of this test are available from the author. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 12 Following the methodology of Gillitzer and Kearns (2005), unit root tests were performed to test the stationarity of the data. Although the Andrews and Ploberger (1994) test found no evidence of any structural break, the sample is split into two periods to display how the trend in New Zealand’s terms of trade differs depending on the period examined. These periods are 1900 to 1973 and 1974 to 2005.10 The results of the Augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) unit root tests are displayed in Table 4. They show that generally New Zealand’s log terms of trade are stationary. However, the ADF unit root test is unable to reject that the terms of trade have a unit root for the period 1974 to 2005 while the PP test can only reject the hypothesis of a unit root when a trend is included. This may be a result of the relatively small sample size and the fact that the terms of trade has generally been increasing over this period. Table 4 – Unit Root Tests for Log Goods Terms of Trade Augmented Dickey-Fuller Phillips-Perron Intercept Trend Intercept Trend 1900-2005 *** *** *** ** 1900-1973 ** * ** ** 1974-2005 ⎯ ⎯ ⎯ *** ***, ** and * denote rejection of the null hypothesis of a unit root at the 1%, 5% and 10% significance levels respectively To estimate the linear trend in the log terms of trade, t tot , (3) is estimated below. The results are displayed in Table 5. tt ttot ε β α + += (3) Table 5 shows that over the period 1900 to 2005 there has been a statistically insignificant downward trend in New Zealand’s goods terms of trade of 0.1% per year. This is an interesting result because it appears to reject the Prebisch-Singer hypothesis that New Zealand’s terms of trade should be trending downwards as a result of the composition of its exports and imports. If the sub-samples are examined, the period from 1900 to 1973 has a statistically insignificant trend, while the period 1974 to 2005 reports a statistically significant upward trend of 0.6% per year in the goods terms of trade. This appears to fit with the argument posed by Kellard and Wohar (2006) in that although a single trend may be present (insignificant in this case), there may be periods in which the trend - and the sign in particular - are different. The results show that for the past 30 years New Zealand has experienced an upward trend in its terms of trade. Consequently, this leads to a different interpretation of the results than if the entire 1900 to 2005 period is examined. However, it is not surprising that the terms of trade have trended upwards over the 1974 to 2005 period given that the date chosen as the break was close to the period where New Zealand experienced some significant downward shocks to the terms of trade that may have meant they were artificially low. 10 These sub-periods were chosen by graphical observation and also with a belief that the UK entering the EEC in 1973 had a large impact on the terms of trade. However, as mentioned above, the oil shocks of the 1970s also occurred at this time, therefore not all of the initial downward movement in the terms of trade can be attributed to the UK joining the EEC. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 13 Table 5 – Trend in Log Goods Terms of Trade 1900-2005 1900-1973 1974-2005 α 6.997*** 6.941*** 6.387*** (0.043) (0.054) (0.132) β -0.001 0.001 0.006*** (0.001) (0.001) (0.001) Q(1) 56.324*** 37.782*** 2.735* Q(5) 78.065*** 54.359*** 4.099 ***, ** and * denote rejection of the null hypothesis at the 1%, 5% and 10% significance levels respectively. Newey-West standard errors are presented in parentheses. Q(1) and Q(5) are the Ljung-Box statistics for autocorrelation at 1 and 5 lags respectively. However as Gillitzer and Kearns (2005) found for Australia, this method of estimating the trend reports considerable autocorrelation in the residuals of (3). This is shown by the highly significant Ljung-Box statistics reported in Table 5 and suggests that there is a level of persistence in the terms of trade (with the exception of the 1974 to 2005 period). To correct for this autocorrelation in the residuals, a lagged dependent variable is added to the regression as shown by (4) where ρ is the autoregressive parameter. () ttt totttot ε ρ β α + + += −1 (4) The results of (4) are displayed in Table 6 and show that the inclusion of the lagged dependent variable reduces the trend coefficient across the entire sample as well as the sub-samples. For the 1900 to 2005 period the downward trend is reduced from 0.1% per year in (8) to 0.0% per year (-0.0001%) in (4) (and it still remains insignificant). The trend is still also statistically insignificant for the period of 1900 to 1973 and the upward trend for the period of 1974 to 2005 has fallen to 0.5% per year (from 0.6%) but is still significant. The long-run parameter, defined as β /(1− ρ ), shows that the above results apply. That is, the trend for the 1974 to 2005 period is positive and highly significant at 0.8% per year. Table 6 – Trend in Log Goods Terms of Trade (Allowing for Persistence) 1900-2005 1900-1973 1974-2005 α 1.904*** 1.889*** 4.272** (0.403) (0.518) (1.643) β -0.000 0.001 0.005*** (0.000) (0.001) (0.002) ρ 0.728*** 0.727*** 0.310 (0.057) (0.074) (0.258) β /(1− ρ ) -0.001 0.001 0.008*** (0.001) (0.001) (0.002) Q(1) 3.159* 2.231 3.923** Q(5) 6.818 7.057 11.476** ρ (Andrews) 0.754 0.846 0.396 Half-Life 2.455 4.145 0.748 ***, ** and * denote rejection of the null hypothesis at the 1%, 5% and 10% significance levels respectively. Newey-West standard errors are presented in parentheses. Q(1) and Q(5) are the Ljung-Box statistics for autocorrelation at 1 and 5 lags respectively. ρ (Andrews) is Andrews (1993) median-unbiased estimator of ρ . β /(1− ρ ) is the long-run parameter. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 14 Also reported in Table 6 is the median-unbiased estimate of ρ based on Andrews (1993). This estimate corrects for biases associated with ordinary least squares estimation with lagged dependent variables (like the form of (4)). The Andrews (1993) estimate of ρ in all three sample lengths is higher than that estimated by least squares to correct for the downward bias. The half-lives of unit shocks are also presented in Table 6 and these show that shocks to the terms of trade do not appear to be persistent (consistent with the finding of stationarity). Shocks appear to dissipate after approximately four years for the period of 1900 to 1973 and have decreased to less than one year for the period 1974 to 2005. Applying this result to the findings of Obstfeld (1982) and Kent and Cashin (2003) suggests that shocks to the terms of trade impact on the New Zealand economy as suggested by the Harberger-Laursen-Metzler effect as they are relatively short-lived. As reported above, there is little evidence that New Zealand’s terms of trade have declined over time, which contradicts the Prebisch-Singer hypothesis. As discussed above, there is no statistical evidence that there were any structural breaks present. However, when examining the sub-periods, there is strong evidence that the terms of trade have experienced an upward trend over the past 30 years. Following Gillitzer and Kearns (2005) methodology, New Zealand’s terms of trade is compared with the ratio of world commodity prices and world manufacturing prices. This series is taken from Grilli and Yang (1988) and is extended to 2005 using IMF commodity price data. Figure 4 below displays the series since 1900. Prior to the mid 1970s, New Zealand’s goods terms of trade and the ratio of world commodity prices to world manufacture prices (relative commodity prices) had a similar downward trend as well as similar cycles. However, following this period the series have diverged. The terms of trade have increased while relative commodity prices have continued decreasing at a more rapid pace. This development has important implications for the New Zealand economy because it suggests that over the last 30 years New Zealand has benefited from a terms of trade that is higher than implied by relative world commodity prices. Figure 4 – Relative Commodity Prices and New Zealand’s Terms of Trade 0 250 500 750 1000 1250 1500 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Index (1900=1000) Ratio of world commodity prices to world manufactures prices NZ goods terms of trade Sources: Grilli and Yang, IMF, NZIER, Statistics New Zealand WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 15 There appear to be three distinct periods when the ratio of world commodity prices to world manufacturing prices experienced different properties. Prior to 1920, the ratio was at a relatively high level. However, after a downward shock around 1920 the level appears to be permanently lower, and stayed around this level until the mid-1970s. Some suggest that the downward shock in the 1920s was a result of increased farm production in Europe once soldiers returned from duty after World War I, which led to lower world primary commodity prices. After the mid-1970s the ratio has declined considerably although it has flattened out in the last 15 years which may be a result of falling relative manufacturing prices (at the same speed as primary commodity prices) as “low-cost” countries such as China increase their presence in international markets.11 Figure 5 displays the ratio of New Zealand goods export prices to world commodity prices and the ratio of New Zealand goods import prices to world manufacturing prices. An interesting observation is that the ratio of New Zealand’s export prices to world commodity prices has been increasing while the ratio of import prices to world manufacturing prices has stayed relatively flat. The upward trend in “relative” export prices also appears to have accelerated after the mid-1970s and helps explain why New Zealand’s goods terms of trade has a smaller downward trend than the ratio of world commodity prices to world manufacturing prices as shown in Figure 5. Because of this, one may ask why New Zealand has not performed better relative to other countries since 1975. New Zealand typically compares itself to other OECD countries and these countries are generally manufactured goods exporters rather than primary commodity exporters. Therefore, rather than being able to draw conclusions from Figure 5 about New Zealand’s relative performance compared with the OECD, it may be more appropriate to compare it to other primary commodity exporters (which are typically developing countries). It suggests that New Zealand has experienced higher prices for its exported goods than other primary commodity exporters. Figure 5 – Relative Export and Import Prices 0 500 1000 1500 2000 2500 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Index (1900=1000) Ratio of import prices to world manufactures prices Ratio of export prices to world commodity prices Sources: Grilli and Yang, IMF, NZIER, Statistics New Zealand Section 4 looks in more detail at some of the reasons why New Zealand’s terms of trade is higher than implied by real world commodity prices and why the ratio of New Zealand export prices to world commodity prices has increased dramatically since the mid 1970s. 11 This point is discussed further in Section 5.2. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 16 3.2 Volatility 3.2.1 Measuring volatility The previous section illustrated that there is no evidence of a secular decline in New Zealand’s terms of trade and in fact the past three decades have seen an upward trend. This section looks at the volatility in the terms of trade to see if it has also changed over time. As illustrated in Figure 1, New Zealand has experienced some large fluctuations in its terms of trade. These have been a result of both export price movements as well as import price movements. For example, the oil price shocks of the mid-1970s had a large impact on import prices while the Korean War of 1950 saw a considerable increase in export prices through the price of wool. Some measures of volatility of the terms of trade are summarised in Table 7 which also shows how volatility has changed over time. The series is again split into the familiar periods of pre-1973 and post-1973 as in the trend discussion above. It is found that volatility (measured by the variance) is almost 70% less in the post-1973 period than the 1900 to 1973 period.12 Also displayed in Table 7 is a measure of the range of the terms of trade relative to the mean. This has fallen by over 50% between the period 1900 to 1973 and 1974 to 2005. Table 7 – Measures of Volatility in New Zealand’s Log Goods Terms of Trade 1900-2005 1900-1973 1974-2005 Variance 0.020 0.023 0.007 Range/Mean* 0.651 0.632 0.311 * The estimate is based on the actual terms of trade data (not logarithms). Table 7 shows how the volatility has changed between the two periods. However, these two periods are arbitrary and chosen by “eye-balling” a graph. It is therefore of interest to test whether a structural break is present in the volatility of the terms of trade. In their paper, Gillitzer and Kearns (2005) apply the Bai and Perron (1998) test to see whether there are any statistically significant breaks in the mean of the absolute log difference in the terms of trade and it is this methodology that is repeated here and displayed in Table 8. Both the UDMax test and the WDMax test, which test for an unknown number of breaks, reject zero breaks against an unknown number of breaks at the 1% significance level. The BIC information criterion indicates that there is one break while the LWZ criterion does not find evidence of any breaks. After allowing for one break, the SupF test cannot reject one break in favour of two or two breaks in favour of three at the 5% significance level. The sequential test using the results of the SupF test therefore finds one break in the volatility of the terms of trade and the Bai and Perron test selects the most likely date as 1980. 12 A similar observation was observed for Australia in the work by Gillizter and Kearns (2005) in that the volatility of its terms of trade has also reduced significantly. It would be interesting to see if this reduction in volatility is more of a world-wide phenomenon, but that is beyond the scope of this paper. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 17 Table 8 – Results of Bai and Perron (1998) Test for Structural Break in Volatility of Terms of Trade Double maximum tests Information criteria SupF(i+1|i) Sequential test Break dates UDMax BIC SupF(2|1) 1 break 1980 26.951*** 1 break 7.748* WDMax LWZ SupF(3|2) 27.484*** 0 breaks 4.180 The double maximum tests are tests for an unspecified number of breaks against the null of zero breaks. Both the WDMax and UDMax test statistics evaluate an F-statistic for 1-5 breaks, with the breakpoints selected by global maximisation of the sum of squared residuals. The UDMax statistic weights the five F-statistics equally, while the WDMax statistic weights the F-statistics such that the marginal p-values are equal across the number of breaks. The WDMax test statistic reported is for a 1% significance level test. The LWZ statistic is a modified Schwarz criterion. The SupF(i+1|I) test is a test for i+1 breaks against the null of i breaks. The sequential test selects the number of breaks stepwise from zero breaks using the SupF test. The break dates are those identified by minimising the sum of squared errors conditional on the number of breaks found. ***, ** and * represent significance at the 1%, 5%, and 10% levels of significance respectively. Figure 6 below displays the absolute log difference in the terms of trade and the means of the two periods selected by the Bai and Perron (1998) test. It is clear that volatility is significantly lower in the period after 1980. It also illustrates that there have been some periods when the volatility in the terms of trade has been significant. Specifically the period between the two World Wars looks to have been a period of significant volatility as well as more one-off periods like the early 1950s and mid-1970s. Another interesting observation is that although the period between 1900 and 1980 experienced higher volatility on average than the period after 1980, this appears to be a result of an increased number of one-off shocks rather than generalised volatility. Section 4.1.2 will go into the reasons why this is likely to have occurred. Figure 6 – Goods Terms of Trade Volatility13 0% 5% 10% 15% 20% 25% 30% 35% 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 % A verage 1980-2005 A verage 1900-1980 Source: Author’s calculation 3.2.2 Decomposing the volatility It is of interest to assess the source of this volatility in the terms of trade. Gillitzer and Kearns (2005) suggest a way to decompose the variance of the terms of trade into the variance of export and import prices and their covariance. The log terms of trade, tott, is the difference between detrended log export and log import prices where X t pand M t pare 13 Volatility is defined as the absolute log difference. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 18 log export and import prices respectively and dt is calculated by averaging the export and import prices and detrending using an HP filter as shown in (6). The purpose of this detrending is to remove common trends between export and import prices. M t X tt pptot −= ( ) ( ) t M tt X tdpdp −−−= (6) The variance of the terms of trade can therefore be decomposed as in (7). Using this method, the terms of trade is split into the periods 1900 to 1979 and 1980 to 2005 and the results are displayed in Table 9 below. The table also splits the series into 20 year periods to get a better appreciation of how the volatility and contributions to the volatility have changed over time. () ( ) ( ) ( ) t M tt X tt M tt X tt dpdpdpdptot −−−−−−= ,cov2varvarvar (7) Export price volatility made the larger contribution to terms of trade volatility in the period from 1900 to 1979 while import price volatility made the larger contribution in the period from 1980 to 2005. However, if the 20 year periods are examined in more detail, the results vary. For example, in the period between 1900 and 1920 import price volatility made a significantly larger contribution to total terms of trade volatility than export price volatility. This pattern was reversed for the periods 1921 to 1940 and 1941 to 1960 where export price volatility made a significantly larger contribution. Although the pattern was again reversed for the three periods after 1960, when import price volatility made the larger contribution. The volatility in the terms of trade was highest in the period 1921 to 1940 and only just higher than the period 1941 to 1960. However, this has reduced dramatically, with volatility in the 1981 to 2000 period approximately five times lower than the period 1921 to 1940. Table 9 – Decomposing the Log Terms of Trade Variance Export Component Import Component -2 x Covariance Component Terms of Trade Variance Variance 1900-1920 0.006 0.020 -0.008 0.018 1921-1940 0.022 0.004 0.001 0.027 1941-1960 0.015 0.004 0.005 0.024 1961-1980 0.007 0.008 0.005 0.019 1981-2000 0.002 0.007 -0.004 0.005 2001-2005 0.009 0.012 -0.016 0.005 1900-1979 0.013 0.009 0.001 0.023 1980-2005 0.004 0.008 -0.005 0.007 WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 19 4 Why have the trend and volatility changed? 4.1 Compositional change in New Zealand’s goods exports 4.1.1 Impact on the trend Figure 5 above reveals that New Zealand export prices have risen relative to world commodity prices. There are a number of possible explanations for why this has occurred. Firstly, it may be that New Zealand goods experience a premium over other similar commodities overseas. This would suggest that the “law of one price” in international commodity markets does not hold and that commodity prices experienced by various countries do not converge in the long run. This could be because New Zealand is becoming more of a ‘price-maker’ in the international market. That is, its producers now have more price setting power now than they did in the past. Or it could be that other countries may have displayed higher productivity growth rates over time, allowing them to be more competitive at lower prices. However, the more likely reason for New Zealand’s export prices outperforming world commodity prices is compositional change. Over history, the types of goods New Zealand exports have gone through significant transformation. Exporting has moved from a focus on a few primary commodities to the exporting of a much broader range of goods.14 This compositional change is illustrated in Figure 7 below. Figure 7 – New Zealand’s Good Export Composition (5 year moving average) 0% 20% 40% 60% 80% 100% 1860 1865 1870 1875 1880 1885 1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Share of total Wool Fishing Forestry Gold Meat Dairy Other Sources: NZIER, Statistics New Zealand As described by Briggs (2003) and shown in Figure 7, wool exports as a proportion of total goods exports have decreased significantly over time, from a peak of 75% in 1860, to just 3% in 2001.15 With the exception of the 1860s “gold-rush” (when gold became the largest 14 Although not the focus of this paper, New Zealand has also experienced a compositional shift towards services exports, as well as that which occurred within goods exports. 15 These numbers are actual figures and therefore do not match accurately with the data from Figure 7 as that data has been smoothed. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 26 5 Factors likely to influence the terms of trade in the future This section of the paper pulls together the findings of the previous sections as well as other recent developments in order to apply them to the outlook for New Zealand’s terms of trade. Although the future of the terms of trade is uncertain, this discussion aims to increase the knowledge about what factors in the future will affect the terms of trade movements. 5.1 Changes in the trend and volatility Section 3 examined some statistical properties of New Zealand’s terms of trade over time. It was found that there was no statistical evidence that the terms of trade has declined since 1900. However, as suggested by Kellard and Wohar (2006), this analysis may be over-simplistic. Looking at the post 1973 period, there is evidence that the terms of trade has been on an upward trend over this period. Much of this increase in New Zealand’s terms of trade (especially relative to world commodity prices) is a result of higher prices received for New Zealand’s exported products. The question is whether this trend will continue into the future. It was also found that this upward trend in the terms of trade exceeded that suggested by relative world commodity prices (Figure 5). Much of this increase in New Zealand’s terms of trade relative to world commodity prices is a result of higher prices received for New Zealand’s exported products. Specifically, New Zealand appeared to be experiencing higher prices for its exports than other primary commodity exporters. The compositional change that New Zealand’s exports have gone through over the past 40 years is arguably the major reason for this strong growth in relative export prices. This therefore suggests that New Zealand needs to continue in this vein in order to extend this trend in prices into the future. The recent “de-commodification” of some of New Zealand’s primary export commodities is also a pattern that may need to continue. Kaplinsky (2005) suggested that this de-commodification gives producers greater price setting power and by developing new “value-added” products such as that demonstrated in Figure 11 would allow New Zealand to continue to develop and open new markets overseas. The discussion to this point has ignored the cyclical properties of the terms of trade and these are important. Even though there may be an upward trend in the terms of trade, there will still be cyclical movements as a result of international developments. This paper has found, however, that the volatility in the terms of trade has decreased and that the New Zealand economy is in a better position to handle shocks to commodity prices as it is no longer focused on exporting a small number of commodities to a small number of countries but has diversified the types of goods it exports and where it exports to. It also found that the largest contributor to this decrease in volatility was falling volatility in aggregate export prices. If New Zealand continues to move away from the exportation of unprocessed primary commodities and into less homogeneous products, this pattern is likely to continue. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 27 5.2 China 5.2.1 Implications for New Zealand’s export prices Kaplinsky (2005) reported that for the first half of 2004, China had a trade deficit on foodstuffs of US$3.7 billion. This is predicted to widen considerably as more of the population enjoys higher income levels as a result of the recent economic boom. For example, according to the US Dairy Association, per capita dairy consumption averaged 6.9 kilograms in 2000 – well below the world average of 46.4 kilograms per capita. It is expected that as income levels rise, the consumption of dairy products in China will increase. This has already started to occur with Chinese imports of whole milk powder increasing by 120% between 2000 and 2004. Figure 13 below displays how the contribution of agriculture to China’s GDP has been trending downwards since 1970. This is a result of both the considerable growth in other areas of the economy as well as a shift in resources from agriculture to other sectors. Kaplinsky (2005) suggests that this is likely to be a result of land conversions from farming to industrial uses, as well as low agricultural productivity growth and this pattern is one that is expected to continue into the future. This therefore leaves New Zealand with a huge opportunity to take advantage of the growing demand in China (due to increases in disposable incomes) to increase its agricultural exports. However, it is likely to face strong competition from other countries in meeting this extra demand from China. Some of this is discussed in Section 5.3.2. If New Zealand was able to gain a larger presence in the Chinese market, this extra demand would likely flow into higher prices for New Zealand’s exported commodities. Figure 13 – Proportion of GDP by Economic Activity for China 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1970 1974 1978 1982 1986 1990 1994 1998 2002 % of GDP Agriculture Mining, Manufacturing and Utilities Construction Wholesale, Retail trade Transport, Communication Other Activities Source: United Nations Statistical Division Although there are likely to be increases in the prices of some of New Zealand’s exported commodities due to increased demand from China, there may also be some offsetting movements in the price of other exported goods. This could be the case for New Zealand manufactured goods exports. As discussed above (and below in Section 5.2.2), China has an extremely large labour force which has enabled it to produce many manufactured products relatively cheaply in comparison to other countries. In a sense they have been WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 28 exporting deflation over recent times. If China continues to play a greater role in the world market and exports manufactured goods at prices lower than other countries, then the downward pressure on world manufacturing prices is likely to continue. However, New Zealand may be able to avoid this price pressure to some extent by differentiating its products from those produced in China and competing on quality rather than price. This is very similar to the “de-commodification” idea of Kaplinsky (2005). If New Zealand is able to export manufactured products that are unique it will give producers greater price setting power and the opportunity to develop niche markets overseas. 5.2.2 Implications for New Zealand’s import prices As discussed above, China has also arguably had a significant impact on the price of manufactured goods traded on the international market. Kaplinsky (2005), using Harmonised System trade data, performed an analysis of EU import categories to study the source and extent to which import prices had fallen. It was found that one third of the imports sourced from China had experienced price falls between 1988 and 2001. This compares with only 9% of products sourced from high income countries over the same period. As a general rule, the higher the per-capita income group of the exporter, the less likely the unit-prices were to fall. Thus, within a large number of product groups, the prices of products exported into the EU by China and low income economies was more likely to decline than the prices of the same product-groupings sourced from other high income economies. Kaplinsky, 2005:17 It was concluded that as China’s participation in global markets increases, the likelihood of price decreases (particularly for manufactures) also increases (as long as China is still catching up with the rest of the world in labour and manufacturing costs). This has implications for New Zealand. As discussed previously, New Zealand is primarily an importer of manufactured goods and, as illustrated by Figure 12, China is a growing source of these imported goods. If New Zealand continues this recent trend of sourcing more of its imports from China (and other “low-cost” nations such as the ASEAN countries) then it should continue to experience falling prices for some of its manufactured imports. However, as with export prices, there are some factors that could partially offset any gains made through lower manufactured import prices (and higher export commodity prices). One of these is the fact that Chinese demand has driven up the price of many hard commodities and these are often used as inputs into production of their manufactured exports. If the prices of these hard commodities continue to increase, then the gains that China has in terms of low labour costs may be offset by the increasing costs of other factors of production which in turn could be passed on through higher manufactured goods prices. Another issue is the fact that New Zealand is a net importer of oil and petroleum products. For the year ended December 2005, New Zealand imported just over $4.2 billion of mineral fuels, approximately 24% more than the previous year. Undoubtedly, this significant increase was due to higher prices for crude oil and part of WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 29 this price increase is a result of extra demand from China.20 If that demand from China were to continue, the price of oil may stay high for some time. 5.3 Other issues 5.3.1 World trade reform Other issues that have the potential to impact on New Zealand’s terms of trade include the progression of world trade liberalisation. Through protectionist policies and export subsidies, agricultural products are extensively supported by governments across the world. This protectionism distorts world trade and results in the oversupply of primary products on the world market, by lowering world prices. A reduction in agricultural protectionist trade policies is one of the critical parts of the WTO’s Doha Development Agenda. Rae and Strutt (2004) model the potential impacts on New Zealand of a reduction in these policies in a Doha framework. They find that the welfare gain to New Zealand is relatively large and it is principally a result of a higher level of the terms of trade. Anderson and Martin (2005) also looked at the impacts of a successful Doha round and the impact on New Zealand (among other countries) and had similar conclusions to Rae and Strutt. The Australian Bureau of Agricultural and Resource Economics (ABARE) have looked at a more generalised reduction in protectionist trade policies and the impact on the dairy industry. They measure the impact of a 100% increase in all tariff-quota volumes and a 50% reduction in all tariff rates. They find this has a large impact on the world price and on Australian and New Zealand production. They estimate price increases of 23.8%, 26.5% and 34.5% for skim-milk powder (SMP), cheese and butter respectively. In another simulation, they examine the impact on world dairy prices from a 50% reduction in subsidised exports in 1999 by the EU and the US. This has the effect of lifting SMP prices by 30.9% and butter prices by 17.4%. In other studies on trade liberalisation, the OECD models the impact of the EU’s Common Agricultural Policy (CAP) reforms.21 These reforms change the way in which subsidies are paid to EU farmers (who are among the most heavily subsidised in the world). Rather than based on their level of production as previously was the case, farmers will now receive the same payment each year. The OECD find that with the lower incentive to farmers both dairy and beef production will fall. More specifically they estimate that (relative to baseline) the beef cattle inventory will be 1% lower in 2006 and 2.4% and 3.2% lower in 2007 and 2008 respectively. This is similar for the dairy cow inventory which is predicted to be 2.2% lower in 2006 and 0.9% lower in 2008. The lower dairy cow inventory will impact on EU dairy production. Butter exports are expected to fall by between 16% and 19% between 2005 and 2008. SMP and whole-milk powder (WMP) exports are also expected to decline by between 8% and 21% for SMP and 12% and 22% for WMP over the same time period. 20 Not all the recent increases in the oil price can be attributed to increased demand from China. There have also been significant capacity constraints recently both from a production and refining perspective and this has also contributed to the price increases, as well as geopolitical uncertainty. 21 The figures quoted are based on the OECD’s “maximum decoupling” scenario. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 30 This reduction in EU production and exports will impact on the world price for dairy products. The world price for butter is expected to be 3.4% higher in 2008 with smaller increases in price for SMP and WMP. Similar price increases were estimated for beef in the longer term as production falls. These simulation studies illustrate the importance to New Zealand of reducing world protectionist trade policies. 5.3.2 Growing presence of South America One issue that does not support as much optimism for world commodity prices from New Zealand’s perspective is the emergence of other primary commodity-based exporters such as South America. This is particularly the case for dairy exports where some countries in South America have experienced rapid growth in their milk production. Brazil, in particular, has experienced 25% growth in its milk production between 2000 and 2005. Brazil’s dairy cow population is currently around 20 million with those cows producing around 25 billion litres of milk.22 Dairy sector growth in Brazil has been constrained by the fact that around 40% of milk is produced on small, non-specialised farms. Per cow productivity, and willingness to grow, remains relatively low in this sector. However, the emergence of increased numbers of large-scale commercial operations with low production costs has pushed up milk supply. Phillips, 2006:2 The potential for Brazil (and other South American countries) to improve their per cow production through the adoption of more modern equipment, the increased use of fertiliser, and the sowing of new pastures mean that it is going to have a growing presence in the global market. This increased milk supply could have a depressing effect on world dairy prices. 5.4 What are the growth impacts? Section 2 of this paper found that, for New Zealand, the level of export prices and import price volatility (and to a lesser extent, total terms of trade volatility) had important implications for New Zealand’s growth. It concluded that the level of (real) export prices between 1950 and 2005 has had a positive impact on New Zealand’s GDP growth while (real) import price volatility has had a negative effect. This section therefore looks at what the outlook for the terms of trade, as discussed above, implies for New Zealand’s economic growth going forward. The previous section described a number of factors that could influence particularly the level of export prices, in the future. These were, for example, the likelihood of further increases in soft commodity prices as demand from China grows as a result of a larger proportion of its population becoming exposed to higher income levels. The trend of New Zealand exporting a greater share of goods with a higher value-added content could also see the level of export prices higher in the future as primary commodities are 22 In comparison to Brazil, New Zealand’s dairy herd is currently around 5 million cattle producing approximately 14 billion litres of milk per year. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 31 “de-commodified”. Finally the continuation of world trade reform, particularly for agricultural products, is also likely to be positive for New Zealand’s export prices. These factors all have the potential to result in higher average export prices in the future and as shown in Section 2.3.1, this could have also have positive economic growth implications for New Zealand. Section 2.3.1 also suggested that terms of trade volatility, particularly volatility in import prices, has had a negative effect on New Zealand’s economic growth. As mentioned above, the majority of New Zealand’s capital investment goods are sourced from overseas and therefore if these import prices were volatile it may deter a firm from making new investment decisions which would have negative growth impacts. Section 3.2 showed how the volatility in New Zealand’s terms of trade has reduced and that the reduction in export price volatility was the significant contributor to this. Therefore it is surprising that export price volatility was found to have had an insignificant effect on economic growth. It may be because this is being picked up in the reduced terms of trade volatility as a whole rather than just the level of export price volatility. Although there was no discussion of the outlook for import price volatility in the previous section, the trend of New Zealand exporting a more diverse array of goods is likely to see the volatility in the terms of trade remain at low levels (by historical standards) in the future and this could also have positive growth implications for New Zealand. However as mentioned above, the outlook for the terms of trade is uncertain and some of the factors that pose positive implications for New Zealand export and import prices could also have negative implications. As a result of this the future growth implications are also uncertain. 6 Conclusion The first part of this paper examined how the trend and volatility of the terms of trade have affected New Zealand’s economic growth since 1950. The literature generally suggests that an upward trend in the terms of trade is growth-enhancing while increased volatility in the terms of trade has an adverse effect on growth. Putting this into a New Zealand context, this paper extended the work of Grimes (2006) and found that the level of (real) export prices has had a positive impact on New Zealand’s economic growth between 1950 and 2005. However, it was also found that the level of (real) import prices has had an insignificant effect on economic growth over this time. This is surprising given that the majority of New Zealand’s capital goods are sourced from overseas and one would expect that higher prices for these goods would deter new investment and therefore reduce economic growth. This analysis also found that volatility in the terms of trade (particularly import price volatility) has had a negative impact on New Zealand’s GDP growth. While this is unsurprising, as increased volatility will deter new investment decisions, what is surprising is that the volatility in export prices was found to have had an insignificant impact on GDP growth. This paper also looked at the historical trends and volatility of the terms of trade to see if they have changed over time. It was found that there was no statistical evidence that the terms of trade has declined since 1900. This appears to reject the Prebisch-Singer hypothesis that New Zealand’s terms of trade should experience a long-term decline. In fact looking at the post-1973 period, there is evidence that the terms of trade has been on an upward trend. The volatility in the terms of trade has also fallen over this period and calculations show that the reduction in export price volatility made the larger contribution WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 32 to the reduction in terms of trade volatility. This observation appears to be a variance with the finding that export price volatility has had an insignificant impact on economic growth. However, it was also found that total terms of trade volatility has had a significant negative impact on growth and therefore the growth effects of export price volatility may be working through this channel. Arguably the major reasons for the increasing trend and reduction in volatility of the terms of trade are compositional change and the de-commodification of some goods exports. However, improved institutions within New Zealand that allow resources to shift more efficiently in response to relative price shocks and the more recent phenomenon of the growing presence of China in the international market are also likely reasons. The conclusions one can draw from this work concerning the outlook for the terms of trade are unclear. There are factors that could result in higher prices for some exports, such as the continued de-commodification of New Zealand’s primary commodity exports, further world trade reform and the growing demand from China as more of the population enjoys higher income levels. However, these could be offset by lower prices for some other exports due to increased supply from some emerging markets such as South America or the continued downward pressure China is putting on world manufacturing prices, including New Zealand manufactured export prices. The same can be said for New Zealand import prices. Some import prices may stay relatively low in future as New Zealand sources more of its manufactured goods from “low-cost” countries such as China and the ASEAN countries. However, China’s growing presence on the world market may also result in other import prices being higher in the future, for example oil prices. Although the outlook for the terms of trade is uncertain, there are polices that could help to highlight the positive factors discussed above which could then have positive growth implications. One of these is the continued push for world trade reform, particularly in agriculture. New Zealand is already playing a role in this area and it will need to continue in this vein. The potential for higher export prices as a result of trade liberalisation is large. Other policies that may help include the development of opportunities for New Zealand firms to export more value-added products. This will give them more pricesetting power overseas and the opportunity to develop niche markets. The marketing of New Zealand products overseas may also assist with this. Also important to consider are the institutions within New Zealand. It was suggested that one reason why New Zealand’s terms of trade has increased over the past three decades is that its institutions have a greater ability to respond to relative price movements than they did in the past, therefore resulting in the terms of trade becoming more endogenous. If policies can be developed that would continue to allow the efficient response to relative price movements, or policies that lower the adjustment costs from shifting these resources, then this could see the terms of trade continue to increase. One area of work that was not examined in this paper was the drivers of import price volatility. It was found that volatility in import prices have had a significant negative impact on New Zealand’s economic growth. If future research is able to examine what has been causing the volatility, then there may be an opportunity to address it and this could also have positive economic growth implications. WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 33 Appendix 1 – Data Description and Source The annual real GDP (1991-1992 prices) data from 1950 to 2005 used in Section 2.3.1 is sourced from the Statistics New Zealand long-term data series. The long-term data for New Zealand’s export and import prices up until 2001 come from Briggs (2003). This data is drawn from work by Easton (1984) and McIlraith (1911). It is updated to 2005 using Statistics New Zealand OTI data. The data sources for Section 3 are shown in Table 1 below. The long-term data for New Zealand’s export and import prices are from the same sources as the data used in Section 2.3.1. However it is extended back to 1900 and then converted into US dollar terms by dividing through by the NZ/US exchange rate. The data on the world commodity and world manufacturing prices in US dollars are taken from Grilli and Yang (1988). Using the IMF’s International Financial Statistics, this data is updated to 2005. Appendix Table 1 – Data Sources for Section 3 Series (annual data) Date Source World Commodity Prices 1900-1986 Grilli and Yang Commodity Price Index - Grilli and Yang (1988) 1987-2005 Updated by author using IMF’s International Financial Statistics (IFS) World Manufacturing Prices 1900-1986 Manufacturing Unit Value (MUV) data - Grilli and Yang (1988) 1987-2005 Updated using IMF MUV series New Zealand Export Prices 1900-2001 New Zealand Institute of Economic Research (NZIER), Briggs (2003) 2002-2005 Statistics New Zealand OTI series New Zealand Import Prices 1900-2001 NZIER, Briggs (2003) 2002-2005 Statistics New Zealand OTI series NZ/US Exchange Rate 1900-1960 NZIER, Briggs (2003) 1961-2005 Reserve Bank of New Zealand (RBNZ) Composition and Destination of New Zealand’s Exports 1900-2001 NZIER, Briggs (2003) 2002-2005 Statistics New Zealand OTI series Exports by Level of Processing 1988-2001 Statistics New Zealand TREC data used in Black, Vink and White (2003) Composition and Source of New Zealand’s Imports 1983-2005 Statistics New Zealand WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 34 Appendix 2 – Decomposing New Zealand’s economic growth The technique below, developed by Fox, Kohli and Warren (2003), is used to decompose the sources of New Zealand’s economic growth. Using a modified Diewert-Morrison decomposition, the contributions of total factor productivity (TFP) growth, labour and capital utilisation, the terms of trade, and the trade balance to New Zealand’s GDP growth for the period of 1983 to 2005 are examined. The technique, originally proposed by Kohli (2003), allows for the fact that the terms of trade effect is not homogeneous of degree zero in prices. This is because a proportional change in export and import prices will change the impact of the terms of trade unless the trade is balanced. Using the same notation and definitions as in Fox et al (2003), nominal GDP growth, real value added and real GDP are decomposed as follows: tt K tt L tttttt S tttt XXHGPR ,1,1,1,1,1,1,1 −−−−−−− ⋅⋅⋅⋅⋅=Γ Real value added is tt K tt L tttttttt S tt XXHGRP ,1,1,1,1,1,1,1 /−−−−−−− ⋅⋅⋅⋅=Γ and real GDP is ( ) tttttttttt S tt PHGP ,1,1,1,1,1,1 // −−−−−− Γ=⋅⋅Γ tt K tt L tt XXR ,1,1,1 −−− ⋅⋅= Where tt ,1− Γis the growth in nominal GDP between periods t-1 and t. Rt-1,t, Gt-1,t, Ht-1,t, tt L X,1−and tt K X,1−are the contributions to nominal GDP growth from changes in TFP, the terms of trade, the trade balance, labour utilisation and capital utilisation respectively. tt S P,1− is the growth rate in domestic prices and tt P ,1−is the contribution to nominal GDP growth from prices.23 Table 1 presents the results for 1991 to 2005 as well as geometric means for the entire period and the periods from 1991 to 1999 and 2000 to 2005. The analysis uses annual Statistics New Zealand National Accounts data for 1990 to 2005. All variables are as defined in Fox, Kohli and Warren (2003) with domestic expenditure equalling the sum of public and private consumption and private investment. To calculate the input of labour, Statistics New Zealand data on the total number of people employed and the average weekly paid hours were multiplied together. Capital stock data was taken directly from Statistics New Zealand which differs from the methodology used by Fox et al as they use a method comparable with that of the OECD. Compensation of employees was taken as the value of labour with the share of labour defined as the value of labour divided by nominal GDP. The share of capital is defined as the remainder over nominal GDP. 23 To see how these equations are calculated please see Fox, Kohli and Warren (2003). WP 06/09 Past, Present and Future Developments in New Zealand’s Terms of Trade 35 For the entire period, nominal GDP grew at an average annual rate of 5.0%.24 However for the period of 2000 to 2005, this annual growth rate in nominal GDP average 6.1%. The difference between ‘real value added’ and ‘real GDP’ is due to changes in the terms of trade and the trade balance. Over the period, the contribution from changes in the trade balance average out to be zero. As a result, the difference between the growth in real value added and the growth in real GDP is due exclusively to improvements in the terms of trade. Although the terms of trade contributed only 0.2% to the average growth in real GDP since 1991, this increased to 0.6% for the period of 2000 to 2005. In fact, for 2004 and 2005, this contribution was significantly higher. For these years the terms of trade accounted for 1.8% and 1.4% respectively (approximately two-fifths) of real GDP growth. Appendix Table 2– Decomposition of GDP Growth using Fox et al (2003) Alternative Methodology Year NGDP Domestic Prices (PS) Real VA Real GDP Terms of Trade (G) Balance of Trade (H) Labour (XL) Capital (XK) TFP (R) 1991 1.040 1.040 1.000 1.015 0.985 1.000 0.991 1.021 1.003 1992 0.997 1.013 0.984 0.992 0.992 1.000 0.985 1.008 0.999 1993 1.022 1.018 1.004 1.000 1.002 1.001 1.000 1.013 0.987 1994 1.071 1.007 1.063 1.056 1.007 1.000 1.013 1.029 1.013 1995 1.075 1.015 1.059 1.055 1.005 0.999 1.026 1.037 0.991 1996 1.066 1.022 1.043 1.042 1.002 0.999 1.015 1.031 0.995 1997 1.054 1.014 1.039 1.036 1.003 1.000 1.011 1.022 1.003 1998 1.037 1.011 1.026 1.032 0.995 1.000 1.006 1.014 1.011 1999 1.024 1.013 1.011 1.014 0.996 1.000 1.000 1.016 0.998 2000 1.048 1.006 1.042 1.042 1.000 1.000 1.003 1.020 1.018 2001 1.059 1.026 1.032 1.029 1.002 1.001 1.012 1.029 0.988 2002 1.074 1.024 1.049 1.038 1.010 1.000 1.015 1.026 0.997 2003 1.054 1.014 1.039 1.049 0.993 0.998 1.018 1.032 0.998 2004 1.064 1.002 1.062 1.044 1.018 0.999 1.011 1.042 0.991 2005 1.069 1.019 1.049 1.034 1.014 1.000 1.016 1.061 0.960 Geometric Means 1991-2005 1.050 1.016 1.033 1.032 1.002 1.000 1.008 1.027 0.997 1991-1999 1.042 1.017 1.025 1.027 0.999 1.000 1.005 1.021 1.000 2000-2005 1.061 1.015 1.045 1.039 1.006 1.000 1.012 1.035 0.992 24 To calculate percentage growth figures from the index numbers from Appendix Table 2 above, subtract one and multiply by one hundred.