INTERNATIONAL FINANCIAL MANAGEMENT

Coursework Assignment
Terms of Trade | Balance of Payments | Exchange Rate Dynamics

Question 1: Terms of Trade

Part (a): Definition and Meaning of Terms of Trade

The Terms of Trade (TOT) is one of the most fundamental concepts in international economics
and finance. In its most straightforward formulation, the terms of trade refers to the ratio of a
country's export prices to its import prices, expressed as an index. It captures the relative value
that a country receives for its exports in comparison to what it must pay for its imports.

Formally, the Terms of Trade index is expressed as:

TOT = (Index of Export Prices / Index of Import Prices) x 100

A TOT index above 100 indicates a favourable terms of trade — the country can purchase a
greater volume of imports per unit of exports. Conversely, a TOT below 100 signals
deterioration, meaning the country must export more to afford the same quantity of imports.
From an international financial management perspective, the terms of trade is a critical
determinant of a nation's real income from trade and its ability to service foreign obligations
(Todaro and Smith, 2015).

Beyond the basic price ratio, economists and financial analysts also refer to the Income Terms
of Trade (ITOT), which adjusts the TOT for changes in export volume:

ITOT = TOT x Volume of Exports

This measure captures the purchasing power of a country's exports. It is particularly relevant for
developing countries that export large volumes of primary commodities but may still see
declining real income if commodity prices fall faster than export volumes rise (Krugman,
Obstfeld, and Melitz, 2018).

The concept of the terms of trade was central to the classical debates around comparative
advantage. David Ricardo's foundational theory established that countries benefit from
specialising in goods in which they have a relative efficiency advantage. However, Ricardo's
framework assumed that the terms of trade would be stable and mutually beneficial. Later
economists, most notably Raul Prebisch and Hans Singer, challenged this assumption, arguing
that the terms of trade systematically move against primary commodity exporters — a finding
with profound implications for developing economies (Prebisch, 1950; Singer, 1950).

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Part (b): Accounting for Deteriorating Terms of Trade in Developing
Countries and Its Effect on Exchange Rates
i. The Prebisch-Singer Hypothesis and Structural Causes
The most influential theoretical explanation for deteriorating terms of trade in developing
countries is the Prebisch-Singer Hypothesis (PSH). First articulated independently by Raul
Prebisch (at ECLAC) and Hans Singer (at the UN) in 1950, the hypothesis asserts that there is a
long-run secular downward trend in the relative prices of primary commodities (exported by
developing countries) compared to manufactured goods (exported by developed countries). This
structural asymmetry condemns commodity-dependent nations to an ever-worsening trading
position over time.

The PSH rests on several foundational arguments. First, the income elasticity of demand for
primary commodities is low — as global incomes rise, consumers in developed countries do not
proportionally increase their demand for raw materials. They spend a rising share of income on
sophisticated manufactured goods and services (Engel's Law extended to trade). Second,
technological progress in developed countries tends to reduce the raw material content per unit
of manufactured output, further suppressing demand for primary commodities. Third, labour
markets in developed nations are more organised, enabling workers to capture productivity
gains as higher wages, while workers in developing countries — often operating in informal or
agricultural sectors — lack the bargaining power to do the same (Cypher and Dietz, 2009).

ii. Commodity Price Volatility and External Shocks

Developing countries that depend on one or two commodity exports are acutely vulnerable to
global commodity price cycles. The boom-and-bust nature of commodity markets — driven by
supply disruptions, geopolitical events, shifts in global demand, and speculative trading in
commodity futures markets — creates extreme uncertainty in export revenues.

During commodity price busts (such as the oil price collapses of the 1980s, 2014-16, and 2020),
oil-exporting developing nations experienced catastrophic deterioration in their terms of trade.
Similarly, Sub-Saharan African countries dependent on cocoa, coffee, copper, or cotton suffered
terms of trade shocks that wiped out significant portions of their foreign exchange earnings (IMF,
2015). The COVID-19 pandemic further disrupted global supply chains and commodity demand,
creating acute short-term deterioration in TOT for many developing nations (World Bank, 2020).

iii. Import Price Inflation

Even when export prices remain stable, developing countries face rising import prices because
their import baskets are dominated by capital goods, petroleum products, pharmaceuticals, and
manufactured consumer goods — all of which are subject to inflation in developed country

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markets and priced in hard currencies such as the US dollar and Euro. This asymmetric import
price pressure erodes the real value of TOT even without any fall in export prices (UNCTAD,
2019).

iv. Trade Policy and Market Power Asymmetries

Developed countries maintain significant agricultural subsidies and protectionist measures
through mechanisms such as the European Common Agricultural Policy (CAP) and US farm
bills. These policies suppress world commodity prices by encouraging overproduction in rich
nations, reducing global demand for the same goods exported by developing countries.
Furthermore, multinational corporations that dominate the processing and retailing of primary
commodities capture a disproportionate share of value added, leaving primary producers with a
thin margin of the final consumer price (Kaplinsky, 2000).

v. Impact of Deteriorating Terms of Trade on Exchange Rates

The linkage between terms of trade and exchange rates is a cornerstone of international
financial management analysis. Deteriorating terms of trade exert powerful depreciatory
pressure on a developing country's currency through multiple transmission channels:

• Reduced Foreign Exchange Supply: A worsening TOT means lower export earnings in
foreign currency. As the supply of foreign exchange (USD, EUR, GBP) in the domestic
foreign exchange market diminishes, basic supply-demand dynamics push the domestic
currency toward depreciation.
• Current Account Deterioration: Persistent adverse terms of trade worsen the trade
balance component of the current account. A structural current account deficit requires
financing through capital inflows or drawdown of foreign reserves. When these are
insufficient, downward pressure on the exchange rate intensifies.
• Speculative Currency Attacks: Investors and currency traders, aware of a country's terms
of trade vulnerability, may speculate against its currency, triggering capital flight and
accelerating depreciation. This was evident during the commodity price crashes that
preceded currency crises in countries like Venezuela, Zambia, and Nigeria (IMF, 2016).
• Central Bank Reserve Depletion: Governments attempting to defend exchange rate pegs
or managed floats in the face of TOT deterioration must deploy foreign reserves. If
reserves are insufficient, forced devaluations follow — as seen repeatedly across Sub-
Saharan Africa and Latin America.
• Imported Inflation and Real Exchange Rate Effects: Currency depreciation triggered by
TOT deterioration increases the local currency cost of imports, generating inflationary
pressure (import-price inflation). This can erode real exchange rate competitiveness
even if nominal depreciation appears to improve it temporarily — the J-curve and
Marshall-Lerner conditions govern whether nominal depreciation ultimately restores the
trade balance.

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Empirical evidence robustly supports this relationship. Spatafora and Tytell (2009) in their IMF
Working Paper found that a 10% decline in the terms of trade is associated with a real exchange
rate depreciation of approximately 3-5% on average in emerging market economies. For highly
commodity-dependent low-income nations, the effect can be considerably larger. The chronic
TOT deterioration experienced by many developing nations thus functions as a long-run driver
of currency weakness, perpetuating the cycle of external vulnerability (Cashin and McDermott,
2002).

Question 2: Balance of Payments and Third World Deficits

Part (a): Definition and Meaning of Balance of Payments

The Balance of Payments (BOP) is a systematic statistical record of all economic transactions
between residents of one country and the rest of the world during a specific period of time,
typically one year. It is compiled in accordance with the framework set out by the International
Monetary Fund (IMF) in its Balance of Payments and International Investment Position Manual
(BPM6, 6th edition). The BOP is not merely an accounting document; it is a fundamental
diagnostic tool for international financial managers, policymakers, central bankers, and investors
who need to understand a country's external financial position.

The BOP is structured into three principal accounts:

• Current Account: Records transactions in goods (merchandise trade), services (tourism,

financial services, intellectual property), primary income (wages, investment income —
dividends and interest), and secondary income (remittances, foreign aid, transfers). The
trade balance in goods and services is the most widely reported component.
• Capital Account: Records capital transfers (debt forgiveness, non-produced non-financial
assets) — relatively minor for most countries but significant in specific cases such as
debt relief for Heavily Indebted Poor Countries (HIPCs).
• Financial Account: Records flows of financial assets and liabilities, including foreign
direct investment (FDI), portfolio investment (equities and bonds), other investment
(loans and trade credit), and changes in reserve assets. The financial account balances
the current and capital accounts — a current account deficit must be financed by a
financial account surplus (capital inflows).

The fundamental accounting identity of the BOP is that, in theory, the sum of the current
account, capital account, and financial account must equal zero (with a statistical discrepancy
item). However, in practice, significant imbalances emerge — particularly in developing

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countries — which signal structural economic vulnerabilities requiring policy intervention
(Krugman, Obstfeld, and Melitz, 2018).

Part (b): Accounting for Balance of Payments Deficits in Third World

Countries
The observation that Third World countries chronically experience BOP deficits is one of the
most well-documented phenomena in development economics and international finance. These
deficits are not random or transitory; they reflect deep-seated structural characteristics of
developing economies. The following analysis identifies the primary causes:

i. Structural Trade Deficits

The most significant source of BOP deficits in developing countries is persistent merchandise
trade deficits. As analysed in Question 1, the deteriorating terms of trade progressively reduces
the value of exports while import bills remain high or grow. Most developing nations are
structural importers of capital goods, machinery, technology, petroleum, and manufactured
consumer goods that they cannot produce domestically at competitive costs. This structural
import dependence, combined with weak export competitiveness, creates enduring trade deficits
that anchor the current account in negative territory (Todaro and Smith, 2015).

ii. Low Export Diversification and Commodity Dependence

Third World countries typically exhibit extremely low export diversification, with export revenues
concentrated in one or two primary commodities — oil, cocoa, coffee, copper, cotton, tobacco —
whose prices are determined in global commodity markets over which they have no control. This
concentration means that adverse commodity price movements directly translate into export
revenue collapses, worsening the trade balance and, consequently, the current account. The
World Bank (2016) documented that low-income commodity exporters face significantly higher
BOP deficit volatility than diversified economies.

iii. Heavy Debt Service Obligations

A major drain on the current account of developing countries is the outflow of income payments
associated with external debt servicing — interest payments on government bonds held by
foreign creditors, dividends and profit repatriation by foreign-owned enterprises, and royalty
payments on intellectual property. Sub-Saharan African nations spend a growing share of their
export earnings on external debt service, reducing the net current account income balance.
UNCTAD (2019) reported that many African nations now spend more than 15% of export
revenues on debt servicing — a level historically associated with BOP crises.

iv. Underdeveloped Services Sector

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While developed economies generate substantial foreign exchange from exports of financial
services, insurance, legal services, software, and tourism, most developing countries run deficits
in the services trade account. They pay more for imported services (shipping, freight insurance,
management consultancy, technology licensing) than they earn from service exports. Tourism,
the most significant service export for many developing nations, is highly cyclical and was
devastated by the COVID-19 pandemic (World Bank, 2020).

v. Low Foreign Direct Investment and Capital Flight

While the financial account can theoretically offset current account deficits through capital
inflows (FDI and portfolio investment), many Third World countries struggle to attract sufficient
FDI due to perceptions of political instability, weak institutions, poor infrastructure, and
inadequate rule of law. Moreover, capital flight — the illicit or legal transfer of domestically
accumulated wealth to foreign financial centres — drains the financial account. The African
Development Bank estimates that capital flight from Africa has exceeded USD 50 billion per
year in recent decades, contributing materially to BOP financing gaps (AfDB, 2020).

vi. Remittances as a Partial Buffer

It is important to note that remittances from the diaspora — recorded in the secondary income
component of the current account — partially offset BOP deficits in many developing nations.
For countries like Nepal, Haiti, El Salvador, and several Sub-Saharan African nations,
remittances exceed foreign direct investment and sometimes even merchandise exports as a
source of foreign exchange. However, remittances are insufficient in scale to eliminate the
structural BOP deficits in most Third World countries (World Bank, 2021).

Part (c): How Balance of Payments Deficits Influence Exchange Rates

The relationship between BOP deficits and exchange rate dynamics is direct and powerful,
mediated through several economic mechanisms. From an international financial management
perspective, understanding this linkage is essential for corporate treasury management,
sovereign debt analysis, and investment decision-making:

i. Supply and Demand in the Foreign Exchange Market

At its most basic level, a BOP deficit implies that the country is spending more foreign exchange
(on imports, debt service, and capital outflows) than it is earning (through exports, FDI, and
remittances). This creates an excess demand for foreign currencies relative to the domestic
currency in the forex market. Under a floating exchange rate regime, this imbalance depreciates
the domestic currency. Under a fixed or managed peg, it depletes the central bank's foreign
reserves as the central bank intervenes to defend the peg — eventually forcing a devaluation
when reserves are exhausted (Obstfeld and Rogoff, 1996).

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ii. The Automatic Adjustment Mechanism
Economic theory suggests that currency depreciation triggered by BOP deficits should initiate an
automatic adjustment process — as the domestic currency weakens, exports become cheaper
for foreign buyers (boosting export revenues) while imports become more expensive for
domestic consumers (suppressing import demand), improving the trade balance over time. This
adjustment is captured by the Marshall-Lerner condition, which states that a depreciation will
improve the trade balance only if the sum of the price elasticities of demand for exports and
imports exceeds unity in absolute value.

In practice, however, this adjustment is slow and imperfect — the J-curve effect describes the
empirical observation that the trade balance initially worsens after depreciation (as import bills
rise faster than export revenues in the short run before volumes adjust) before improving in the
medium to long run. Moreover, for many developing countries, the sum of trade elasticities may
be too low (due to inelastic demand for essential imports and commodity exports) to generate
the required adjustment (Bahmani-Oskooee and Ratha, 2004).

iii. Speculative Dynamics and Currency Crises

Persistent BOP deficits attract negative attention from international currency markets. Investors
and speculators may anticipate that a country's reserves will become insufficient to maintain its
exchange rate commitment, triggering a speculative attack — a sudden massive sale of the
domestic currency — that forces an abrupt and disorderly devaluation. The first-generation
currency crisis models (Krugman, 1979) formalised this relationship, showing that persistent
BOP deficits financed by reserve drawdown inevitably trigger speculative crises. Historical
examples include the Mexican Peso Crisis (1994), the Asian Financial Crisis (1997-98), and
Argentina (2001-02), all of which involved unsustainable BOP deficits preceding currency
collapses.

iv. IMF Conditionality and Exchange Rate Policy

Third World countries with severe BOP deficits frequently turn to the International Monetary
Fund (IMF) for balance of payments support. IMF programs — Extended Fund Facility (EFF),
Stand-By Arrangements (SBA), Rapid Financing Instrument (RFI) — provide emergency foreign
exchange liquidity but typically come with structural adjustment conditionalities that include
currency devaluation or liberalisation, fiscal austerity, interest rate increases, and trade
liberalisation. While these programs stabilise the BOP and exchange rate in the short run, the
social costs of austerity are often severe, particularly for low-income populations in developing
nations (Stiglitz, 2002; IMF, 2016).

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Conclusion
This coursework has examined two foundational concepts of international financial management
— the Terms of Trade and the Balance of Payments — with particular focus on the structural
vulnerabilities of developing and Third World economies. The analysis has demonstrated that
the deteriorating terms of trade experienced by commodity-dependent developing nations is not
a transitory phenomenon but a structural feature of the global trading system, rooted in demand
asymmetries, technological change, and unequal market power — as theorised by Prebisch and
Singer and confirmed by decades of empirical evidence.

The consequences of TOT deterioration — reduced export revenues, current account deficits,
reserve depletion, and currency depreciation — feed directly into the chronic BOP deficits that
characterise Third World economies. These deficits, in turn, perpetuate exchange rate
weakness, increase the domestic currency cost of foreign debt, and constrain the fiscal space
available for development spending. The result is a structural trap that demands strategic policy
responses: export diversification, regional trade integration, commodity revenue management,
debt restructuring, and attraction of productive foreign investment.

For international financial managers advising corporations or governments operating in

developing country contexts, understanding these dynamics is not merely academic — it is
essential for effective currency risk management, investment appraisal, and strategic financial
planning in an increasingly complex and interconnected global economy.

References
1. African Development Bank Group (2020). African Economic Outlook 2020: Developing Africa's
Workforce for the Future. Abidjan: AfDB.
2. Bahmani-Oskooee, M. and Ratha, A. (2004). 'The J-Curve: A Literature Review.' Applied
Economics, 36(13), pp.1377-1398.
3. Cashin, P. and McDermott, C. J. (2002). 'The Long-Run Behaviour of Commodity Prices: Small
Trends and Big Variability.' IMF Staff Papers, 49(2), pp.175-199.
4. Cypher, J. M. and Dietz, J. L. (2009). The Process of Economic Development. 3rd ed. London:
Routledge.
5. International Monetary Fund (2015). World Economic Outlook: Adjusting to Lower Commodity
Prices. Washington, D.C.: IMF.
6. International Monetary Fund (2016). IMF Staff Discussion Note: Neoliberalism: Oversold?
Washington, D.C.: IMF.
7. Kaplinsky, R. (2000). 'Globalisation and Unequalisation: What Can Be Learned from Value Chain
Analysis?' Journal of Development Studies, 37(2), pp.117-146.

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8. Krugman, P. R. (1979). 'A Model of Balance-of-Payments Crises.' Journal of Money, Credit and
Banking, 11(3), pp.311-325.
9. Krugman, P. R., Obstfeld, M. and Melitz, M. J. (2018). International Economics: Theory and
Policy. 11th ed. Harlow: Pearson Education.
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MA: MIT Press.
11. Prebisch, R. (1950). The Economic Development of Latin America and Its Principal Problems.
New York: United Nations.
12. Singer, H. W. (1950). 'The Distribution of Gains between Investing and Borrowing Countries.'
American Economic Review, 40(2), pp.473-485.
13. Spatafora, N. and Tytell, I. (2009). Commodity Terms of Trade: The History of Booms and Busts.
IMF Working Paper WP/09/205. Washington, D.C.: IMF.
14. Stiglitz, J. E. (2002). Globalisation and Its Discontents. New York: W.W. Norton and Company.
15. Todaro, M. P. and Smith, S. C. (2015). Economic Development. 12th ed. Harlow: Pearson
Education.
16. UNCTAD (2019). Trade and Development Report 2019: Financing a Global Green New Deal.
Geneva: UNCTAD.
17. World Bank (2016). Commodity Markets Outlook. Washington, D.C.: World Bank Group.
18. World Bank (2020). Global Economic Prospects, June 2020: Pandemic, Recession: The Global
Economy in Crisis. Washington, D.C.: World Bank Group.
19. World Bank (2021). Migration and Development Brief 35: Recovery: COVID-19 Crisis Through a
Migration Lens. Washington, D.C.: World Bank Group.

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