Dynamic Effects of Terms of Trade Shocks : The Impact on Debt and Growth

The recent empirical literature on the economic effects of terms of trade shocks highlights not only the direct effects on growth, but also the resulting changes in volatility and debt. We link the procyclicality of sovereign debt to terms of trade shocks and provide theoretical underpinnings for standby facilities such as the “Exogenous Shocks Facility” recently created by the IMF. By modeling international capital market imperfections and changes in creditworthiness during adverse terms of trade shocks, we show that transitions can involve excessive adjustment as debt decumulation overshoots its long run equilibrium to prolong the adjustment recession. Our model adds a novel dynamic dimension to the Harberger-Laursen-Metzler effect. In contrast to the previous terms of trade literature, we highlight that the precise nature of the capital imperfection is key to the results. When credit depends not on the level of debt but on the debt to equity ratio the model naturally features dynamic effects that are not found in previous models. It also highlights that how a country responds to terms of trade shocks depends importantly on whether the country is a creditor or debtor. Finally we assess the welfare costs associated with terms of trade shocks. For plausible parameterizations we find that a 20 percent deterioration in the terms of trade may lead to a welfare loss on the order of 10 to 15 percent