Disturbing Deterioration in Terms of Trade in Asia
Senior Executive Fellow
Economic Research Center
Fujitsu Research Institute
Terms of trade in Asian countries have maintained a long-term decline, damaging profit from international trade. Here we examine the excessive price competition over industrial goods among Asian countries which is causing that decline.
‘Terms of trade’, the first concept that students learn in international economics, is used to measure how much a country can import with a given amount of export. Usually derived by dividing the export price by the import price, it is often expressed as an index using a certain year as the base year. A high index means that that country can sell its products for high prices and buy goods cheaply from overseas, meaning an improvement in social welfare. While terms of trade data is easily obtained, it attracts little interest among the general public and newspapers and other media seldom discuss the issue. A look at recent trends in terms of trade, however, reveals a lesser-known side of the Asian economy.
Rapid deterioration in terms of trade in Korea, Taiwan and Japan
Figure 1 shows trends in terms of trade in key Asian countries. These are worsening in most countries, but the relative nature of terms of trade means that for one country to do well, another should be doing badly, producing a flat overall trend. Figure 1 reveals a sharp improvement for Australia, driven by two factors: its status as a food and resource exporter, and the steep rise in the price of those goods over the past decade.
What about other Asian countries? The deterioration in Korea’s terms of trade is particularly striking. A victim of the 1997 Asian economic crisis, Korea used assistance from the International Monetary Fund to push through an ambitious structural reform package and stage a swift recovery. However, Korea’s terms of trade were locked in a steep downward slide even prior to that. The problem is that export prices have continued to fall even as import prices rise, to the extent that Korea now needs to export three times as much as it did 20 years ago to import the same amount. Like Japan, Korea doesn’t have much in the way of resources. It imports most of its crude oil, mineral resources and food, and prices for resources like these have continued to climb. Meanwhile, intense price competition over export products such as electrical products, cars and steel prevents manufacturers from introducing price hikes. Of course, given the rapid rise in productivity for these products, prices could be expected to fall. What isn’t shown in the figure, however, is that other manufacturing nations without resources such as Germany, Switzerland and Sweden aren’t experiencing the same terms of trade turndown.
Terms of trade for electrical machinery and steel plunge particularly steeply
Why are some countries with manufacturing-driven economies managing to maintain their terms of trade, while others have seen an ongoing weakening? The key to this puzzle is divulged in Figure 2, which shows Japan’s terms of trade for key industries. The terms of trade index here subtracts input prices from production prices. The index slump is the result of sales prices being unable to keep up with the higher cost of raw materials and intermediate goods, putting pressure on added value such as wages and corporate profit. What the index reveals is that terms of trade are not worsening in all export industries—only for electrical machinery and steel has the downturn been pronounced, while the situation in other industries is far more moderate. In Korea’s case, electrical machinery and steel make up a significant portion of exports, which may be why its terms of trade have deteriorated so badly.
The decline in terms of trade for steel is no mystery. The deterioration really became evident as of around 2004 when prices for iron ore, coking coal and other raw materials skyrocketed. Growth accelerated in China and other developing countries in Southeast Asia, the Middle East, South America and throughout the world, causing a surge in demand for steel raw materials, and with Australia and Brazil the only sources for these, raw material prices have soared. Because of international competition, however, Japanese manufacturers have been unable to put up their product prices, so their only option has been to sacrifice wages and profit. The situation is presumably the same in Korea.
Electrical machinery hit particularly hard
The electrical machinery industry has faced an even more fundamental problem. Starting with textiles and miscellaneous goods, labor-intensive assembly industries began moving into Asian countries where wages were cheap. The electrical machinery industry was no exception, but it was major Western multinationals that led the transfer of production bases over to Asia. By keeping planning, design, R&D and key components at home even as they shifted assembly processes out to low-wage Asian countries, they boosted their price competitiveness. The Asian countries too welcomed that direct investment from developed countries with open arms as a means of promoting national economic development. Japanese firms producing everything in-house back in Japan were slow to recognize what was happening and lost price competitiveness as a result. This trend moved into high gear as of the late 1990s as digital technology became the mainstream. Modularization and horizontal integration proceeded on a global scale, forcing a rapid decline in the price of IT devices. Plummeting terms of trade in Japan, Korea and Taiwan are the outcome of savage price competition among these three countries over products such as semiconductors, flat-panel televisions and computers. Products relying on integrated technologies such as autos, precision machinery and general machinery have not generally suffered the same fate.
Western firms avoid price competition
In Germany, the US and other developed countries, firms have chosen to avoid the commodification of their products and price competition with the newly-emerging economies. With steel, they have specialized in special steels and other high-performance steel materials, while in the electrical machinery industry, they have almost entirely abandoned consumer electronics and IT devices, focusing management resources instead on energy, medical care, the environment and other systems and infrastructure business. Japanese firms remain strongly committed to skilled manufacturing, a stance which traps them in endless price competition with countries like Korea and China. They have managed to survive through wage cuts and tighter profits, but these tactics too are reaching their limits. Most flat-panel TV, mobile phone and computer production has been moved offshore, with only a fraction remaining at home. For excavators and other construction equipment, firms have developed a business model whereby they add a GPS function to machinery to track its operational status in real time even after sales, securing profit through services such as maintenance. Korea took the standardized mass production at which Japan once excelled and surpassed Japanese efficiency, but the downside of this has been poorer terms of trade.
Exchange policies depress terms of trade even further
Another factor determining terms of trade is the exchange rate. For example, if the yen strengthened now, it would make imports cheaper in yen terms, so to the extent that yen-denominated prices for exports didn’t change, terms of trade would improve. In other words, social welfare would pick up by the extent to which import prices had fallen. However, the data suggest that terms of trade fluctuations are currently not as great in any country as exchange rate fluctuations; they are in fact stable. In such conditions, a strong yen means that Japanese exports become more expensive in foreign currencies, depressing sales. Consequently, both import and export prices fall, leaving terms of trade virtually unchanged. If the yen were conversely to weaken, the yen-denominated price of imports would rise but manufacturers would also have room to push up export prices, so again there would be little change in terms of trade. In other words, exchange rate fluctuations will not have much effect on terms of trade.
However, for exporters, a weak domestic currency makes selling easy. Rival products imported from other countries become more expensive, and if the prices for export products are set in the domestic currency, conversion into foreign currencies makes them cheaper, boosting price competitiveness in offshore markets. Strongly export-dependent industries all hanker after a weaker domestic currency. That’s why Japan’s primary business association, Keidanren, begins to grumble when the yen appreciates. In Korea’s case, the won slumped heavily against the dollar in the 1997 Asian economic crisis and has since remained low, holding even very recently at around 20 percent less than it was prior to the crisis. The Korean government is apparently intervening to weaken the won, but the slump in prices for Korea’s products and the weak won have compounded to produce a long-term deterioration in Korea’s terms of trade.
Trading losses expand
Changes in national income caused by changes in terms of trade are expressed as trading gains or losses. Better terms of trade should translate into a higher level of social welfare. That relationship can be expressed as follows, with the value indicated in the Cabinet Office’s national income statistics:
Gross domestic income (GDI) = gross domestic product (GDP) + trading gains
As is apparent from this formula, even if exports increase and GDP grows, if terms of trade deteriorate, real income won’t increase and social welfare won’t improve. The reason that economists call policies that force exports up through exchange operations and low prices ‘starvation exports’ is that they don’t boost social welfare. The ongoing deterioration of terms of trade in countries such as Korea and Taiwan is having just that negative effect, and Japan too needs to be careful. Japan’s terms of trade were stable for many years but have suddenly worsened since around the year 2000, resulting in trading losses of more than 20 trillion yen in 2007 and 2008. Firms have cut wages and margins and the government too has used major yen depreciation-intended interventions to push up the growth rate, but the result has been a massive outflow of income. The same thing is presumably happening in other Asian countries too. Japan, Korea and Taiwan account for virtually all world production of IT devices, but ongoing mutual competitive currency devaluation and price-cutting has lost them a massive amount of trading gains. Company leaders and trade policy-makers alike need to give serious thought as to how this situation could be improved.
(original article : Japanese)