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THE TERMS OF TRADE, COMMODITY PRICES, EXCHANGE RATE AND BALANCE OF PAYMENTS PROBLEMS

The sharp appreciation of the rand lead to larger part of the marginal rand spent in the economy being spent on imports. The graph below shows the relationship between the real exchange rate and the share of the increase in total spending (existing of domestic demand and export demand) that is on imports. 

Where the share of the increase in yearly total demand in the third quarter of 2002 (i.e. the increase in total demand from the third quarter in 2001 to the third quarter in 2002) being provided by imports was below 10%, this has  increased to slightly above 70% in the third quarter of 2003. A large part of additional spending is being leaked out abroad. The sharp appreciation of the rand lowered the relative price of importables and is largely responsible for the leakages abroad of the increase in total demand. 

The current account of the balance of payments only weakened slightly despite the large leakages abroad of increases in total demand. This paradox can be explained by what happened to the terms of trade during this period of leakages. The terms of trade is simply the price index of exports divided by the price index of imports. An improvement in a country's terms of trade (this happens when the prices of exports increase at a faster rate than the prices of imports) enables that country to import more without having to produce more exports or to sell a part of its assets to foreigners (this happens when there is an inflow of capital).

South Africa's terms of trade over the last of couple of years has shown a marked improvement. Because an improvement in the terms of trade increases the supply of foreign exchange relative to the demand, the exchange rate strengthens. The graph below shows the relationship between the real effective exchange rate and the terms of trade. The terms of trade leads the real effective exchange rate by 4 quarters. As a rule of thumb a 1% improvement in the terms of trade leads to a 3% improvement in the real effective exchange rate.

The improvement in the terms of trade is largely attributable to an increase in the prices of precious metals. The graph below shows the Commodity Price Bureau (CRB) precious metals price index, measured in dollar terms.

The CRB index is equally weighted consisting of gold, platinum and diamonds and paints a good picture of the stimulus that came from increases in the prices of precious metals. As a rule of thumb a 6% increase in the price of precious metals leads to an 1% improvement in the terms of trade. A significant part of the appreciation of the rand since its low in December 2001 can be attributed to the increase in commodity prices.

The terms of trade can also deteriorate when the prices of commodities imported rise sharply. One such a commodity is oil. Here the rule of thumb is that the terms of trade deteriorates by 1% for every 22% increase in the price of oil. The graph below shows the price of a barrel of Brent Crude from the first quarter of 1990 to the third quarter of 2003.

The higher price of oil could however not erode the positive effects of the increases in commodity prices and the terms of trade has improved over the last couple of years.

The graph below shows the actual course of the current account of the balance of payments as well as the course it would have had, had the terms of trade remained at the level of the fourth quarter 2001.

It can be clearly seen from the graph that the improvement in the terms of trade has protected the current account of the balance of payments. Had the terms of trade remained at its fourth quarter 2001 level the current account deficit would have been more than 3% of the Gross Domestic Product (GDP) . The windfall coming from the improvement in the terms of trade is the equivalent of 2% of GDP. 

The risk is that the current account is in a vulnerable position after the demand stimulus of 2003. The demand stimulus came in the form of a sharp appreciation of the rand, lower interest rates and an expansionary fiscal policy. Declines in commodity that will lead to a deterioration in the terms of trade will reveal the vulnerability of the current account and will put the rand under downward pressure.

The increase in commodity prices and the improvement in the terms of trade is a windfall and it is therefore risky to stimulate the economy. The policies being followed is reminiscent of yesteryear and from past experience we know that stimulating the economy during a windfall leads to a sharp depreciation of the rand when the windfall is unwound. There is thus a danger that in 2004 we can again experience a sharp depreciation of the rand when the deficit on the current account becomes too large. This could be the result of a decline in commodity prices and/or when imports increase sharply.

Last updated 29 December 2003

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