Friday, July 1, 2022

Cost of production is surging

They say a chart represents a thousand words.

One of the defining trends across New Zealand has been rising terms of trade, or the ratio of export prices to import prices.

It is a key measure of purchasing power.

Think of it as the relative price of a kilogram of butter to a television.

It has risen 47% since 2001, at an average rate of 2.1% a year.

NZ has been able to buy a greater volume of imports relative to the volume of exports we have needed to sell simply because we received a large relative price gain.

We’ve been able to afford more televisions.

Not only has the terms of trade risen, it has also been less volatile than what we saw during the 1960s and 1970s, providing economic stability.

In lottery ticket parlance, NZ won big and experienced a major economic tailwind 

Economic growth and living standards have been supported by a relative price shift in our favour.

What if that ratio now starts to go down or no longer goes up?

Or it starts being more volatile, like it was many decades ago?

Between 2001 and 2021 export prices rose 26%, hardly stellar, but moving up.

Over the same period import prices fell 14%.

The NZ dollar is 35% higher than back then so the increases are smaller than the increase in global prices.

However, the gap between the movement in export prices relative to import prices over the decade is stark and reflected in the terms of trade.

Capital good import prices declined 61% between 2001 and 2021.

Consumer durable good prices declined 62%.

Passenger car prices fell 18%.

Consumers were the big winners.

Some of the terms of trade boost are compositional changes and the de-commodification of some goods exports as we have shifted up the value-add chain.

Capital goods and consumer goods have risen as a share of total imports and their prices have generally declined.

Cost of production surge

The fall in many import prices partly reflects technology.

Lower prices for many capital goods incorporate falling prices for computer equipment, which takes account of technological enhancements in calculating the split between prices and quality-adjusted import computer volumes.

A computer or technology product built in 2001 is far less powerful than the ones we have today.

As are many items that include technological features.

But one wonders how much reflects globalisation.

We have experienced an era of rising accessibility (i.e. the China Free Trade Agreement) and reducing trade barriers, though many trade interventions have been discriminatory rather than liberalising too.

As the world became more and more connected, accessing cheap labour and outsourcing took hold to cheaper and low-cost producers, manufacturing goods became the new commodities and faced pricing pressures.

Global trade peaked as a share of gross domestic product in 2008 according to the World Bank, rising from 25% in 1970 to more than 60%.

Prior to covid many trade battlegrounds were being drawn post 2010, notably the US and China. 

Covid, the Ukraine and geopolitics has taken this to a whole new level as various shocks unfold.

The vulnerabilities of being hugely exposed to a global supply chain are real.

Onshoring is replacing offshoring in some countries.

Many countries’ cost advantages in manufacturing have been whittled away.

Inflationary pressures are rampant.

The cost of production is surging, almost across the board.

Many decades ago, the Prebisch-Singer hypothesis stated that the price of primary commodities should decline relative to the price of manufactured goods.

As we get richer, we spend more on luxury and manufacturing foods, whereas food is a staple.

There is a political reality to how far food prices can rise.

The theory was wrong for decades.

The commodities outperformed the manufacturing goods. 

A higher terms of trade was reflected in a higher NZ dollar.

The theory could be set for a comeback.

A consequence and offset would be a persistently lower NZ dollar on average.

But consumers of those previously cheap imported manufacturing goods could be in for a fright.

The disappearance of a terms of trade tailwind would dampen growth prospects, making it even more imperative we lift productivity performance.

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