Terms of Trade Volatility and Precautionary Savings in Developing Economies

Abstract

This paper investigates the link between terms of trade volatility and long-term output growth in developing countries. I find that differences in terms of trade volatility account for 20% of the cross-country variation in growth from 1980 to 2009. The magnitude is arresting: a standard-deviation difference in exposure to terms of trade volatility between two countries is associated in the data with a 16-percentage-point difference in overall output growth. A decomposition of output growth distinguishes pure capital accumulation from the dynamic effects of productivity growth. The data show that capital accumulation in the 1970’s and 80’s was highest in countries with high terms of trade volatility, which later shifted their portfolios away from domestic capital and into foreign bonds. The reallocation of precautionary savings from domestic to foreign assets led to falling output in countries with volatile terms of trade. A neoclassical capital accumulation model has significant precautionary savings associated with terms of trade risk. Opening foreign bond markets in the model induces a shift away from capital and a fall in output in price-volatile countries, reproducing my finding from the data.