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Do Terms of Trade and Its Volatility

Matter? Evidence From Economic
Escalation of China
a a
Syed Tehseen Jawaid & Syed Ali Raza
a
IQRA University , Karachi , Pakistan
Published online: 12 Feb 2015.

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 Journal of Transnational Management, 20:3–30, 2015
Copyright # Taylor & Francis Group, LLC
ISSN: 1547-5778 print=1547-5786 online
DOI: 10.1080/15475778.2015.998136

Do Terms of Trade and Its Volatility Matter?

Evidence From Economic Escalation of China

SYED TEHSEEN JAWAID and SYED ALI RAZA

IQRA University, Karachi, Pakistan
Downloaded by [Syed Tehseen Jawaid] at 16:16 12 February 2015

This article makes a unique contribution to the literature with

reference to China, being a pioneering attempt to investigate the
effect of terms of trade and its volatility on economic growth of China
by using annual time series data from 1980 to 2010 and by applying
rigorous econometric techniques. Autoregressive distributed lag
(ARDL) cointegration and Johansen and Juselius cointegration
methods suggest the significant negative long-run relationship of
terms of trade and volatility of terms of trade with economic growth.
Four different sensitivity analyses indicate that initial results are
robust. Rolling window analysis was performed to find the yearly
effect of terms of trade and its volatility on the economic growth of
China. Results show that the coefficient of terms of trade on economic
growth remains negative from 1985 to 1988, 1994 to 1995, 1998 to
2002, and from 2006 to 2008. Variance decomposition method
shows a unidirectional causal relationship between terms of trade
and economic growth runs from terms of trade to economic growth
and a bidirectional causal relationship between volatility of terms of
trade and economic growth in China. It is concluded that less volatile
terms of trade are better for economic growth. Policy makers should
critically analyze the reasons for deterioration of terms of trade in the
years 1985 to 1988, 1994 to 1995, 1998 to 2002 and from 2006 to
2008. Either this happened because of increases in import prices or
decreases in export prices, or increases in export prices that are less
than increases in import prices. This analysis will be beneficial in
finding the contents of export and import by which terms of trade
deteriorate and form growth-enhancing policies.

Received June 2014; revised September 2014; accepted November 2014.

Address correspondence to Syed Tehseen Jawaid, IQRA University, Karachi-75300,
Pakistan. E-mail: stjawaid@hotmail.com
Color versions of one or more of the figures in the article can be found online at
www.tandfonline.com/wtnm.

3
 4 S. T. Jawaid and S. A. Raza

KEYWORDS economic growth, terms of trade, volatility

INTRODUCTION

The economy of China has been undergoing a spectacular process of growth

for almost four decades. During 2008, GDP growth rate was 9% even con-
sidering the world financial crises. China has become one of the largest
export-oriented countries; China’s export volume has been increasing sub-
stantially. In 1978, the total volume of trade was US$ 20.64 billion, which
was 9.7% of GDP and USD 2563.26 billion in 2008, which was 59.8% of
GDP. China is the third largest trading state of the world. During the past
three decades, China’s terms of trade show different trends. In the 1980s,
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the average terms of trade was 101.66; in the 1990s it was 104.21, and in
the past decade sharp decline to 89.27 was noticed. On the other hand, in
the 1980s, the average growth in real GDP was 9.96%; in the 1990s it was
10.67%, and in the past decade it was 10.47%.
The issue is whether the terms of trade are associated with economic
growth. This study tries to examine this question by employing long annual
time series data of China from 1980 to 2010. Numerous literature discussed
the relationship between terms of trade and economic growth. Many of them
are cross-sectional and some of them are time series studies.1 However, thus
far, China has not been considered in time series analysis. Moreover, this
study investigates the effects of terms of trade and its volatility on economic
growth in China.

Motivation of the Study

In most of the studies mentioned in section two, cross-country data have
been used to analyze the relationship between terms of trade and economic
growth. The usage of cross-country data may be suitable for answering great-
er questions, on average. It provides only the aggregate average results of the
sample but it fails to explain the effect on each individual country to formu-
late and manage domestic policies. This article makes a unique contribution
to the literature with reference to China, being a pioneering attempt to inves-
tigate the impact of terms of trade and volatility of terms of trade on econ-
omic growth in China using the annual time series data from 1980 to 2010
and by applying rigorous econometric techniques. Our study is different
from the past studies on terms of trade-growth nexus in four novel ways.
First, this study is the first attempt to analyze the effects of terms of trade
and volatility of terms of trade on economic growth in China. China is a large
open economy, so it is necessary to analyze the relationship of terms of trade
and economic growth in China. Second, we have not restricted our study to
any particular econometric technique to estimate the long-run relationship,
 Terms of Trade and Volatility: China 5

which were done in past studies (Borkin, 2006; Wong, 2004, 2010). In this
study, to ascertain the robustness of the results of long-run coefficients, we
use four different sensitivity analyses to check the robustness of initial results.
First, by using additional variables in basic models, second by using the dif-
ferent proxies of volatility of terms of trade, third by using dynamic ordinary
least square estimation, and last by using the fully modified ordinary least
square estimation procedure.
Third, in this study we use the advance econometric technique of rolling
window estimations to analyze the trend and range of coefficients of the
long-run model throughout the sample. The rolling windows estimation
method provides the coefficient of each year of a sample size, which clearly
shows the behavior of the coefficients throughout the sample period. The
rolling window analysis provides the coefficients of terms of trade and vola-
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tility of terms of trade for each sample year.

Fourth, in this study we use more advanced econometric techniques,
namely the variance decomposition method, to analyze the causal relation-
ship between considered variables. The variance decomposition method
has several advantages over other methods of causal relationships of time
series data. The results of other causality tests weaken their reliability
because they cannot analyze the strength of causal relationship beyond the
selected time. The variance decomposition method provides the magnitude
of the predicted error variance for a series accounted for by innovations from
each of the independent variable over a different time.2 This ensures that our
conclusions regarding the causal relationship of terms of trade and volatility
of terms of trade with economic growth are accurate and more reliable.
The remainder of the article reviews some theoretical and empirical
literature on terms of trade and economic growth, and discusses the model-
ing framework. Next, estimations and results are discussed and the study
concludes with policy recommendations.

REVIEW OF LITERATURE

This section reviews some theoretical and selected cross-country as well as

time series empirical studies.

Theoretical Underpinning
Numerous studies have argued about the Prebish-Singer (PS) hypothesis.3
The PS hypothesis states that the terms of trade of primary product specializ-
ing country will deteriorate over time more than the producers of manufac-
tured goods will deteriorate. In contrast, Sarkar and Singer (1991) argue that
the price of manufacturing exports of developing countries have decreased
 6 S. T. Jawaid and S. A. Raza

since the 1980s more than have manufacturing exports of developed

countries.
On the other hand, the Harberger-Laursen-Metzler (HLM) affect states
that a country’s real income and aggregate savings fall due to adverse shocks
in terms of trade, which results in decline in its current account balance.4
Bhagwati (1958) hypothesizes the concept of immiserizing growth. The
immiserizing growth theory states that when technological change or an
increase in factor endowments move outward from the production possi-
bility frontier of a country, the key benefit from economic growth is offset
by the secondary loss due to the deterioration of the terms of trade.
Jawaid and Waheed (2011) explain the channel between terms of trade
and economic growth. According to them, an increase in terms of trade
results in efficient allocation of resources, which leads to high productivity
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and economic growth. Higher economic growth enables a country to move

resources for research and development and this leads to quality improve-
ment in the country. Consequently, export price increase results in further
improvement in terms of trade.

Empirical Evidence
Most empirical studies suggest that the improvement in terms of trade is ben-
eficial for economic growth. Some studies argue that deterioration in terms of
trade is favorable for economic growth.
Batra and Pattanaik (1971) discuss that a decrease in terms of trade is
capable of elevating national welfare in the presence of inter-sectoral wage
differential. Bhagwati and Brecher (1980) argue that deterioration in terms
of trade possibly will improve national income if capital is internationally
mobile. Anam (1988) claims that a decline in terms of trade of an economy
(when involved in quota-induced rent-seeking activities) improves national
welfare by diminishing the social cost of imports.
Some selected literature available in Table 1 shows a positive relation-
ship between terms of trade with economic growth and trade balance.

EMPIRICAL FRAMEWORK

After analyzing the theoretical and empirical work, the model to examine the
impact of terms of trade and its volatility on economic growth in China is
derived using the production function framework. The production function
in general form is as follows:

Y ¼ f ðA; L; K Þ ð3:1Þ

Where Y is the real gross domestic product, L is the labor force, K is the capi-
tal stock and A is the total factor productivity. It has been assumed that effect
 Downloaded by [Syed Tehseen Jawaid] at 16:16 12 February 2015

TABLE 1 Overview of the Relationship between Terms of Trade and and Economy Growth

Authors Work Sample Statistical technique Results and recommendation

Arize (1996) Effects of terms of trade on 1973(2) to 1992(4) of 16 Cointegration In most of the countries, significant
trade balance countries over floating positive long run relationship exist
exchange rate period between terms of trade and trade
balance
Mendoza Volatility of terms of trade 9 industrial and 31 Stochastic endogenous The effect of volatility of terms of
(1997) affects savings and developing countries for growth model trade could be negative or positive
growth. the period of 1971 to depending upon the degree of risk
1991. aversion. If risk aversion is low,
volatility of terms of trade
diminishes welfare and economic
growth. Conversely, if risk aversion
is high, increase in the volatility of
terms of trade sustains economic
growth but still reduces social

7
welfare. The empirical results
indicate the robust positive
relationship between rate of
change of terms of trade and
economic growth. In contrast, the
depressing and robust relationship
exists between terms of trade
uncertainty and economic growth.
Kaneko (2000) Analyzes the connection — The study uses endogenous Results show that when a country
between specialization growth model with two specializes in consumption
pattern and growth rate of factors, physical and commodities, there is significant
a growing economy. human capital and build positive relationship between
up a three-sector growth terms of trade and economic
model of international growth. On the other hand, if
trade with intertemporal country specialized in capital
optimizing behavior and commodities, the economic growth

(Continued )
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TABLE 1 (Continued)

Authors Work Sample Statistical technique Results and recommendation

endogenous physical is not affected by the terms of

Bleaney & Investigate the impact of
Greenaway terms of trade, volatility of
(2001) terms of trade and real
exchange rate on
investment and growth.
Panel of 14 Sub-Saharan
African countries by using
annual data from 1980 to
1995. These countries
heavily depend on
exports of primary
commodities.
capital with the addition
of human capital.
For estimation they use
stochastic endogenous
growth model developed
by Mendoza (1997).
Generalized
Autoregressive
Conditional
Heteroscedasticity
(GARCH) model has also
trade. Accordingly, variation in
growth can be caused by an
industrial policy, which affects
comparative advantage.
The results indicate that volatility of
terms of trade has significant
negative impact on growth. Both
growth and investment are high
when the terms of trade get
improved. The findings suggest
that trade reforms has been
strongly growth enhancing.

8
been used to estimate
volatility of both terms of
trade and real exchange
rate.
Hadass & Relationship between terms They considered 19 The empirical analysis has Results suggest that positive terms of
Willaimson of trade and economic countries for the period of been done through trade movement reduce economic
(2001) growth. 1870 to 1940. ordinary least square growth of primary product
(OLS) estimation exporters. Findings also confirm
procedure. the asymmetry in growth impact
between core and periphery. In the
pre war period, alteration in terms
of trade explain not more than
one-fifth of economic growth,
which is observed by the GDP per
capita growth rate. However, they
cover few developing countries in
their sample that remain poor up to
the World War II.
 Downloaded by [Syed Tehseen Jawaid] at 16:16 12 February 2015

Cashin & The relationship between Five OECD countries by Structural VAR model has The outcome suggests that the
McDermott terms of trade shock and using different quarterly been used for median terms of trade shock
(2002b) current account balance. time series data for estimations. account for only a small share of
different countries. the inconsistency of current
account balance in the United
Kingdom, the United States, and
Canada. On the other hand, shocks
in terms of trade are found
significant in proportion of
variation in current account
balance in cases of New Zealand
and Australia.
Blattman, the relationship between Data have been taken from The empirical analysis has The results show that terms of trade
Hwang, & terms of trade and its pre World War II era been done through have significant positive impact on
Williamson volatility with economic between the periods from ordinary least square economic growth, while volatility
(2003) performance. 1870 to 1938 of 19 core (OLS) estimation of terms of trade has negative
and 16 periphery procedure. impact on economic growth. These
countries. findings are asymmetry between

9
Otto (2003) Examines the responses of
the trade balance to terms
of trade shocks.
Hamori (2008) Empirically identifies the
relationship between
terms of trade and trade
balance.
core and periphery.5 They
concluded that terms of trade and
their volatility played an important
role in explaining growth in the
less-industrialized periphery than
more industrialized core countries.
55 small open economies. The study uses structural It is found that a positive terms of
These countries were VAR model. trade shock results in improvement
developing and small in the trade balance. This outcome
OECD economies. is parallel for both small OECD and
developing countries.
G-7 countries by using Cointegration and It is concluded that deterioration in
annual data from 1971 to sensitivity analysis have the terms of trade will not certainly
2003. The G-7 countries been performed. improve trade balance of a country
were Canada, France, in the long run.
Germany, Italy, Japan,

(Continued )
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TABLE 1 (Continued)
Authors Work
Wong (2010) Analyzes the impact of
terms of trade and its
volatility on economic
growth in Japan and
Korea.
Fatima (2010) Empirically examines the
impact of changes in
10
terms of trade on income.
Jawaid & Investigate the effects of
Waheed terms of trade and its
(2011) volatility on economic
growth.
Jawaid & Raza Examine the effects of terms
(2013) of trade on economic
growth in India.
Sample Statistical technique Results and recommendation
United Kingdom, and
United States.
Time series data from Johansen cointegration Findings indicate that real GDP per
1960(Q1) to 2006(Q3) for technique has been used capita and terms of trade are
Japan and 1971(Q1) to to find long-run mutually determined. In contrast,
2006(Q3) for Korea. relationship. generally terms of trade volatility is
negatively correlated with real GDP
per capita for both countries. The
author comes to the conclusion
that favorable and less volatile
terms of trade are important for
economic growth..
Using time series data of Trend analysis has been It is found that deterioration of terms
Pakistan from 1990 to performed. of trade has negative impact on
2008. economic growth. The study
suggests that diversification of
output and export structure is
essential for Pakistan.
Five-year average annual The empirical analysis has Cross-country regression results
data from 2004 to 2008 of been done through suggest that a significant positive
94 developed and ordinary least square relationship exists between terms
developing countries. (OLS) estimation of trade as well as volatility of terms
procedure. of trade with economic growth.
The sensitivity analysis indicates
that the results are robust.
Annual time series data The empirical analysis has Result suggests significant positive
from the period 1980 to been done through ARDL long-run relationship between
2010. bound testing estimation terms of trade and economic
procedure. growth.
 Terms of Trade and Volatility: China 11

of terms of trade and volatility of terms of trade on economic growth oper-

ates through A6. The empirical models for estimations are developed as
follows:
Yt ¼ b0 þ b1 Lt þ b2 Kt þ b3 Tt þ et ð3:2Þ
Where, et is the error term, L is the total labor force and T represents the
terms of trade and its volatility. Real gross fixed capital formation as a per-
centage of GDP has been used as a proxy for capital stock because of una-
vailability of data of capital stock.7 The expected signs for labor and capital
stock are positive, whereas the signs of T are to be determined. Annual time
series data were used from 1980 to 2010. All data were gathered from World
Bank’s official database.8 The volatility of terms of trade is measured by Gen-
eralized Autoregressive Conditional Heteroscedasticity (GARCH).9 All vari-
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ables are used in logarithm form.

The augmented Dickey–Fuller (ADF)10 test and the Phillips–Perron
11
(PP) unit root test are used to examine the stationary properties for the
long-run relationship of time series variables. The augmented Dickey–Fuller
(ADF) test is based on the equation given as follows:

X
k
DYt ¼ a0 þ a1 Yt1 þ dj DYtj þ et
j¼1

Where et is pure white noise error term, D is first difference operator, Yt

is a time series, a0 is the constant and k is the optimum numbers of lags of the
dependent variable. The augmented Dickey–Fuller (ADF) test determines
whether the estimates of coefficients are equal to zero. The ADF test provides
cumulative distribution of ADF statistics. The variable is said to be stationary
if the value of the coefficient a1 is less than the critical values from the Fuller
table. The Phillips–Perron unit root test is also based on t-statistics associated
with estimated coefficients of q . The Phillips–Perron (PP) unit root test
equation is as follows:

DYt ¼ a þ q Yt1 þ et
The present study employs two cointegration methods, namely autore-
gressive distributed lag (ARDL) cointegration and Johansen and Juselius
(1990) cointegration methods to analyze the long-run relationship between
terms of trade and economic growth in China. The Autoregressive Distribu-
ted Lag (ARDL) method of cointegration developed by Pesaran and Pesaran
(1997), Pesaran and Shin (1999), Pesaran, Shin, and Smith (2000, 2001) has
been used with the help of unrestricted vector error correction model to
investigate the long-run relationship between terms of trade and its volatility
with economic growth. The ARDL approach has several advantages over
other cointegration methods. The ARDL approach may apply irrespective
 12 S. T. Jawaid and S. A. Raza

of whether underlying variables are purely I(0), I(1), or mutually

co-integrated.12 The ARDL approach has estimated better small sample
properties.13 In the ARDL procedure, the estimation of results is possible
even if the explanatory variables are endogenous.14 The ARDL model is
developed for estimations as follows:

X
p X
p X
p
DYt ¼ w0 þ w1 DYt1 þ w2 DLt1 þ w3 DKt1
i¼1 i¼1 i¼1
X
p
þ w4 DTt1 þ c1 Yt1 þ c2 Lt1 þ c3 Kt1 þ c4 Tt1 þ lt
i¼1

Where w0 is constant and lt is white noise error term, the error correc-
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tion dynamics are denoted by a summation sign whereas the second part of
the equation corresponds to long-run relationships. The Schwarz Bayesian
Criteriona (SBC) has been used to identify the optimum lag of model and
each series. In the ARDL model, we first estimate the F-statistics value by
using the appropriate ARDL models. Second, the Wald (F-statistics) test is
used to investigate the long-run relationship among the series. The null
hypothesis of no cointegration is rejected if the calculated F-test statistics
exceed the upper critical bound (UCB) value. The results are inconclusive
if the F-test statistics fall between the upper and lower critical bound. Lastly,
the null hypothesis of no cointegration is accepted if the F-statistics are below
the lower critical bound.
The Johansen and Juselius (1990) cointegration technique is also used to
analyze the existence of the long-run relationship of terms of trade and vola-
tility of terms of trade with economic growth. This Johansen–Juselius cointe-
gration test is based on ktrace and kmax statistics. First ‘‘trace test’’ cointegration
rank ‘r’ is as follows:

X
n
ktrace ¼ T Inð1  kj Þ
j¼rþ1

Second, kmax maximum number of cointegrating vectors against r þ 1 is

presented in following way:

kmax ðr; r þ 1Þ ¼ T Inð1  kj Þ

The null hypothesis of the Johansen–Juselius cointegration is that there
is no long-run cointegration among the variables. If the null hypothesis is
rejected that indicates a significant long-run relationship among the series
of variables. Furthermore, we use four different sensitivity analyses to check
the robustness of initial results: First, by using additional variables in basic
models, second by using the different proxies of volatility of terms of trade,
 Terms of Trade and Volatility: China 13

third by using dynamic ordinary least square (DOLS) estimation, and last, by
using the fully modified ordinary least square (FMOLS) estimation procedure.
The rolling window estimation method has been used to analyze the
range of coefficients of the long-run model throughout the sample. The roll-
ing windows estimation method provides the coefficient of each year of a
sample size, which clearly shows the behavior of the coefficients throughout
the year. The stability of long-run results is analyzed by using the cumulative
sum and cumulative sum of square estimations. Last, we use a more
advanced econometric technique, namely the variance decomposition
method to analyze the causal relationship between terms of trade and its
volatility with economic growth.

ESTIMATIONS AND RESULTS

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Augmented Dickey–Fuller (ADF) and the Phillips–Perron (PP) unit root test
are used to examine the stationary properties for long-run relationship of
time series variables. Table 2 represents the results of unit root test.
Results of Table 2 confirm that all variables are stationary at first differ-
ence; this means that the combination of one or more series may exhibit
long-run relationship among the variables of equation 3.2. Table 3 and
Table 4 show the results of the ARDL cointegration method of terms of trade
and volatility of terms of trade models, respectively.
The ARDL results suggest the rejection of null hypothesis of no cointe-
gration in both models because the value of the F- statistics is greater than
upper bound critical value at 1% level of significance in favor of alternative
hypothesis that the valid long-run relationship exists among variables of
equation 3.2 in China. Table 5 represents the calculated and critical values

TABLE 2 Stationary Test Results

ADF test PP test

I(0) I(1) I(0) I(1)

Variables C C&T C C&T C C&T C C&T

Y 0.64 2.12 4.27 4.19 0.23 2.34 3.47 3.39

L 2.47 3.14 4.31 4.14 2.36 2.89 4.55 4.23
K 1.14 2.48 4.45 4.27 0.49 2.87 4.24 4.15
T 1.28 1.53 4.90 4.60 1.27 1.72 5.58 5.48
VT 1.35 1.19 4.15 4.72 1.93 1.68 6.00 6.33
Note: The critical values for ADF and PP tests with constant (c) and with constant & trend (C&T) 1%, 5%
and 10% level of significance are: 3.711, 2.981, 2.629 and 4.394, 3.612, 3.243 respectively.

VT shows the volatility of terms of trade.
Source: Authors’ estimation.
 14 S. T. Jawaid and S. A. Raza

TABLE 3 Lag Length Selection and Bound Testing for Cointegration of Terms of Trade Model

Lags order AIC HQ SBC F-test statistics

0 6.963 6.904 6.775 38.224

1 21.659 21.364 20.457
2 22.155 21.626 20.719

1% level of significant.
Source: Authors’ estimation.

TABLE 4 Lag Length Selection and Bound Testing for Cointegration of Volatility of Terms of
Trade Model

Lags order AIC HQ SBC F-test statistics

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0 16.044 15.985 15.853 23.497

1 28.996 28.705 28.045
2 29.987 29.466 28.273

1% level of significant.
Source: Authors’ estimation.

of TRACE statistics and maximum eigenvalue statistics of the J–J cointegration

test.
Results indicate the rejection of the null hypothesis of no cointegration
in both models at a significance level of 5% in China in favor of alternative
hypothesis, that is, the existence of one or more cointegrating vectors. Both
cointegration tests confirm the existence of long-run relationship among vari-
ables of equation 3.2 in China.
Table 6 represents the estimations of ordinary least squares. The results
of labor force (L) and capital (K) are having an expected positive sign and are
highly significant. Results confirm the significant negative long-run relation-
ship between terms of trade and economic growth in China. One of the poss-
ible reasons of negative effect of terms of trade is when demand of China’s
export increases, the demand for import contents for the production may

TABLE 5 Results of J J Cointegration Test

Null hypothesis Trace 5% critical Max. eigen 5% critical

Model no. of CS(s) statistics values value statistics values

Terms of Trade None 58.968 40.175 30.797 24.159

At most 1 28.172 24.276 18.963 17.797
At most 2 9.209 12.321 8.309 11.225
Volatility of Terms None  86.653 63.876 38.981 32.118
of Trade At most 1 47.672 42.915 26.249 25.823
At most 2 21.423 25.872 13.595 19.387
Source: Authors’ estimation.
 Terms of Trade and Volatility: China 15

TABLE 6 Long-Run Determinants of Economic Growth

Model of terms of trade Model of volatility of term of trade

Variables Coeff. t-stats Prob. Coeff. t-stats Prob.

C 0.515 13.724 0.000 0.782 17.165 0.000

L 0.617 7.298 0.000 0.209 7.098 0.000
K 0.231 2.207 0.037 0.249 2.466 0.021
T 0.229 1.817 0.082 0.224 1.970 0.060
Adj. R2 0.998 0.998
D.W stats 1.421 1.485
F-stats (Prob.) 4200.264 (0.000) 4253.605 (0.000)
Source: Authors’ estimation.
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TABLE 7 Unit Root Test for Residuals

Model Test Without trend With trend

Terms of Trade ADF Test 3.635 3.652

PP Test 3.635 3.607
Volatility of Terms of Trade ADF Test 3.429 3.912
PP Test 3.433 4.324
Note: The critical values for ADF and PP tests with constant (c) and with constant & trend (C&T) 1%, 5%
and 10% level of significance are 3.711, 2.981, 2.629 and 4.394, 3.612, 3.243 respectively.
Source: Authors’ estimation.

also increase. Increase in import demand leads to increase in import price,

which results in deterioration of terms of trade. Export price also increases
due to increase in foreign demand but not as much as import price. There-
fore, as the terms of trade decrease, on the other hand, economic growth
is enhanced due to increase in production. Results also show the negative
and significant long-run relationship between volatility of terms of trade
and economic growth. The findings are consistent with Bleaney and
Greenaway (2001), Mendoza (1997), and Wong (2010). It confirms that less
volatile terms of trade are necessary for economic growth in China.15
Augmented Dickey–Fuller (ADF) and Phillips–Perron (PP) tests are used
to analyze the unit root test for stationary residuals. Results of Table 7 show
that residuals of both models are stationary at level and variables are at first
difference. This confirms the valid long-run relationship exists between the
considered variables in China.

SENSITIVITY ANALYSIS

In this section, four different sensitivity analyses were performed to check the
robustness of initial results: First, by using additional variables in basic
 16 S. T. Jawaid and S. A. Raza

models, second, by using the different proxies of volatility of terms of trade,

third, by using dynamic ordinary least squares (DOLS) estimation procedure,
and last, by using fully modified ordinary least squares (FMOLS) estimation
procedure.

Additional Variables
The degree of confidence among the relationship between dependent and
independent variables is tested through sensitivity analysis. If the coefficient
of independent variables gives the same sign and significance after putting
additional variables in the basic model, then they infer that the results are
robust. The results infer fragile if the coefficient of independent variables
does not give the same sign or significance or both after putting additional
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variables in the basic model (Levene & Renelt (1992). We used the following
model to perform a sensitivity analysis.

Yt ¼ b0 þ b1 Lt þ b2 Kt þ b3 Tt þ b4 Zt þ 2
=t ð5:1Þ
Where 62t represents the error term and Z represents a subset of vari-
ables that are theoretically related with the economic growth. Adeniyo and
Abiodun (2011) consider health expenditure; Barro (1996) considers life
expectancy, inflation, primary school enrollment, and fertility rate; and
Yanikkaya (2003) considers export as a percentage of GDP as other major
determinates of economic growth. Jawaid and Waheed (2011) use life
expectancy, export as percentage of GDP, and fertility rate as other determi-
nants of economic growth in their sensitivity analysis. In this study, primary
school enrollment (PSE), life expectancy (LEX), inflation (INF), export as per-
centage of GDP (EXP), and fertility rate (FER) are considered as determinants
of economic growth for sensitivity analysis. The results of sensitivity analysis
are reported in Table 8, where we have shown the coefficients of terms of
trade and volatility of terms of trade on economic growth with the inclusion
of different relevant variables in the basic model.
It is confirmed from Table 8 that the coefficient of terms of trade and its
volatility remain the same sign and significance, despite inclusion of relevant
variables in the basic model. Consequently, it can be concluded that the
relationship of terms of trade and volatility of terms of trade with economic
growth is robust in China.

Different Proxies of Volatility

Different measures of volatility have been used in empirical studies.16 The
measures of volatility include standard deviation, generalized autoregressive
conditional heteroscedasticity, five-year moving averages, and five-year mov-
ing standard deviations.17 To test the robustness of volatility of terms of trade,
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TABLE 8 Results of Sensitivity Analysis with Additional Variables

Model of terms of trade Model of volatility of terms of trade

Model Coeff. of T t-stats. (prob.) Adj R2 D.W F-stats (prob.) Coeff. of T t-stats. (prob.) Adj R2 D.W F-stats (prob.)

Basic Model 0.229 1.817 (0.082) 0.998 1.421 4200.264 (0.000) 0.224 1.970 (0.060) 0.998 1.485 4253.605 (0.000)
EXP 0.511 2.024 (0.054) 0.983 1.479 2126.73 (0.000) 0.487 2.484 (0.022) 0.987 1.377 2236.235 (0.000)

17
PSE 0.914 4.354 (0.000) 0.988 1.782 2052.02 (0.000) 0.405 2.316 (0.032) 0.998 1.723 2546.726 (0.000)
INF 0.608 4.399 (0.000) 0.994 1.673 2012.59 (0.000) 0.853 5.446 (0.000) 0.999 1.966 4368.353 (0.000)
FER 0.550 4.541 (0.000) 0.987 1.913 3798.287 (0.000) 0.496 2.412 (0.026) 0.998 1.435 2241.135 (0.000)
PSE, INF 0.641 4.009 (0.001) 0.994 1.702 3620.441 (0.000) 0.856 5.345 (0.000) 0.999 1.952 3451.478 (0.000)
EXP, PSE 0.869 3.842 (0.001) 0.989 1.749 4582.622 (0.000) 0.419 2.244 (0.038) 0.998 1.857 2016.447 (0.000)
EXP, PSE, INF 0.517 3.163 (0.005) 0.995 1.787 3712.401 (0.000) 0.227 3.019 (0.008) 0.999 1.661 2995.074 (0.000)
FER, EXP, PSE 0.869 1.786 (0.088) 0.989 1.748 3514.047 (0.000) 0.343 1.817 (0.082) 0.998 1.755 1714.308 (0.000)
Source: Authors’ estimation.
 18 S. T. Jawaid and S. A. Raza

TABLE 9 Test for Robustness of Volatility of Terms of Trade Model by Different Proxies

GARCH MSDT MAVG

Variables Coeff. t-stats Prob. Coeff. t-stats Prob. Coeff. t-stats Prob.

C 0.782 17.165 0.000 0.824 4.455 0.000 0.808 7.363 0.000

L 0.209 7.098 0.000 0.850 12.835 0.000 0.558 4.282 0.000
K 0.249 2.466 0.021 0.527 4.351 0.000 0.301 2.553 0.019
T 0.224 1.970 0.060 0.120 2.367 0.027 0.476 1.792 0.088
Adj. R2 0.998 0.98 0.998
D.W stats 1.485 1.556 1.523
F-stats (Prob.) 4253.605 (0.000) 2855.929 (0.000) 2940.404 (0.000)
Source: Authors’ estimation.
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we considered five-year moving standard deviation (MSTD) and five-year

moving average (MAVG) as other measures of volatility of terms of trade.
Table 9 represents the results of sensitivity analysis of volatility of terms of
trade model.
Table 9 clearly confirms that it does not matter what proxy of volatility
of terms of trade is considered. The results showed the same sign and signifi-
cance level of volatility of terms of trade. This confirms that our initial results
are robust.

Dynamic Ordinary Least Squares

The robustness of the relationship between dependent variable and explana-
tory variables in long run is tested through the dynamic ordinary least
squares (DOLS) technique developed by Stock and Watson (1993). This
method involves estimating the dependent variable on the explanatory vari-
able by using the levels, leads, and lags of the explanatory variable. This
method resolves the issues of small sample bias, endogeneity, and serial cor-
relation problems by adding the leads or lags of the explanatory variable
(Stock & Watson, 1993). The equation of the DOLS model is as follows:

X
p X
k
Yt ¼ u0 þ u1 Xt þ hji DXi;tj þ et
j¼p i¼1

Where Yt is the dependent variable, Xt is the vector of explanatory vari-

ables and D is the lag operator. Table 10 represents the results of dynamic
ordinary least squares of terms of trade and volatility of terms of trade mod-
els. We have run our model of DOLS by taking the lead and lag of 2.
Results confirmed that the coefficient of focus variable, namely terms of
trade and volatility of terms of trade (T), remains the same sign and signifi-
cance. Consequently, it can be concluded that the relationship between
 Terms of Trade and Volatility: China 19

TABLE 10 Results of Dynamic Ordinary Least Square (DOLS)

Model of terms of trade Model of volatility of terms of trade

Variables Coeff. t-stats Prob. Coeff. t-stats Prob.

C 0.575 10.625 0.000 0.690 5.440 0.000

L 0.454 5.139 0.000 0.805 2.941 0.009
K 0.289 2.461 0.023 0.343 3.252 0.005
T 0.220 2.210 0.043 0.203 3.141 0.007
Adj. R2 0.998 0.998
D.W stats 1.421 1.801
F-stats (Prob.) 4200.264 (0.000) 1921.919 (0.000)
Note: Lag ¼ 2, Lead ¼ 2.
Source: Authors’ estimation.
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terms of trade and volatility of terms of trade with economic growth in China
remain the same and initial results are robust.

Fully Modified Ordinary Least Squares

The fully modified ordinary least squares (FMOLS) technique developed by
Phillips and Hansen (1990) is used to analyze the robustness of our initial
results of ordinary least squares. FMOLS provides the optimal estimates of
the cointegration equation.18 The FMOLS modifies the OLS to control the
problems of serial correlation and endogeneity in the regressors.19 Results
of FMOLS are presented in Table 11.
The results of FMOLS confirm that the coefficient of the focus variable,
namely terms of trade and volatility of terms of trade (T), remains the same
sign and significance. Consequently, it can be concluded that the relationship
between terms of trade and volatility of terms of trade with economic growth
in China remain the same and initial results are robust.

TABLE 11 Results of Fully Modified Ordinary Least Square (FMOLS)

Model of terms of trade Model of volatility of terms of trade

Variables Coeff. t-stats Prob. Coeff. t-stats Prob.

C 0.968 1.128 0.270 0.348 0.788 0.438

L 0.748 9.890 0.000 0.889 8.355 0.000
K 0.885 4.729 0.000 0.126 4.841 0.000
T 0.243 10.692 0.000 0.165 2.405 0.029
Adj. R2 0.967 0.964
D.W stats 1.658 1.738
Source: Authors’ estimation.
 20 S. T. Jawaid and S. A. Raza

ROLLING WINDOW ANALYSIS

The rolling window estimation method has been used to analyze the range of
coefficients of the long-run model throughout the sample. Rolling windows
estimation method provides the coefficient of each year of a sample size that
clearly shows the behavior of the coefficients throughout the sample period.
Table 12 and 13 and Figure 1 and Figure 2 represent the results of yearly
coefficients of terms of trade and volatility of terms of trade.
Two standard deviation bands show the upper and lower bounds.
Results of Table 12 and Figure 1 indicate that the coefficient of considered
variable terms of trade shows very mixed results. The coefficient of terms
of trade on economic growth remains negative from 1985 to 1988, 1994 to
1995, 1998 to 2002, and from 2006 to 2008. The coefficient of terms of trade
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on economic growth also shows positive coefficient from 1989 to 1993, 1996
to 1997, 2003 to 2005, and from 2009 to 2010. On the other hand, results of
Table 13 and Figure 2 show that the coefficient of volatility of terms of trade
on economic growth have negative coefficients throughout the sample
period.

TABLE 12 Long-run Coefficients of Terms of Trade

Year Coeff.

1985 0.399
1986 0.369
1987 0.268
1988 0.073
1989 0.234
1990 0.032
1991 0.132
1992 0.310
1993 0.173
1994 0.518
1995 0.265
1996 0.061
1997 0.407
1998 0.644
1999 0.731
2000 0.410
2001 0.192
2002 0.147
2003 0.028
2004 0.416
2005 0.331
2006 0.932
2007 2.100
2008 0.756
2009 0.282
2010 0.096
Source: Authors’ estimation.
 Terms of Trade and Volatility: China 21

FIGURE 1 Coefficient of TOT and its two S.E. bands based on rolling OLS (Dependent Vari-
able: GDP).
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STABILITY OF LONG-RUN MODEL

The stability of the long-run model in the sample size is evaluated by using
the cumulative sum (CUSUM) and CUSUM of squares test on the recursive
residuals. The CUSUM test detects systematic changes from the coefficients
of regression, whereas the CUSUM of the square test detects the sudden
changes from constancy of regression coefficients (Brown, Durbin, & Ewans,
1975).
Figures 3–6 represent the results of CUSUM and CUSUM of square tests
respectively. Results indicate that the statistics of both CUSUM and CUSUM of
square tests lie within the interval bands of 5% confidence interval. Results
suggest that there is no structural instability in the residuals of equation 3.2
of economic growth.

FIGURE 2 Coefficient of volatility of TOT and its two S.E. bands based on rolling OLS
(Dependent Variable: GDP).
 22 S. T. Jawaid and S. A. Raza

TABLE 13 Long-run Coefficients of Volatility of Terms of Trade

Year Coeff.

1991 0.017
1992 0.058
1993 0.118
1994 0.166
1995 0.203
1996 0.378
1997 0.301
1998 0.338
1999 0.383
2000 1.570
2001 1.112
2002 0.703
2003 0.482
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2004 0.104
2005 0.029
2006 0.197
2007 0.255
2008 0.299
2009 0.337
2010 0.278
Source: Authors’ estimation.

FIGURE 3 Plot of cumulative sum of recursive residuals. The straight lines represent critical
bounds at 5% significance level.

CAUSALITY ANALYSIS

The generalized forecast error variance decomposition method under the

vector autoregressive (VAR) system has been used to analyze the strength
of the causal relationship of terms of trade and volatility of terms of trade
 Terms of Trade and Volatility: China 23
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FIGURE 4 Plot of cumulative sum of recursive residuals. The straight lines represent critical
bounds at 5% significance level.

with economic growth. The variance decomposition method provides the

magnitude of the predicted error variance for a series accounted for by
innovations from each of the independent variables over different periods.
Hye (2012), Shahbaz et al. (2012), and (Wong, 2010) have used this approach
to find causal relationship among considered variables. Table 14 represents
the results of variance decomposition analysis of terms of trade model.
Results of Table 14 show that in the first round the change in economic
growth is caused 71.07% by its own innovations; 18.08% by labor; 7.14% by

FIGURE 5 Plot of cumulative sum of squares of recursive residuals. The straight lines rep-
resent critical bounds at 5% significance level.
 24 S. T. Jawaid and S. A. Raza
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FIGURE 6 Plot of cumulative sum of squares of recursive residuals. The straight lines rep-
resent critical bounds at 5% significance level.

capital; and 3.72% by terms of trade. In the second period, 66.83% is caused
by its own innovations;, 18.47% by labor; 6.31% by capital; and 8.39% by
terms of trade. In period 5, the shocks in economic growth are caused

TABLE 14 Results of Variance Decomposition Approach of Terms of Trade

Period GDP LAB CAP TOT

Variance Decomposition of GDP

1 71.066 18.078 7.138 3.717
2 66.828 18.470 6.310 8.392
3 37.991 42.515 11.115 8.379
4 26.739 39.670 15.662 17.929
5 17.891 36.665 25.911 19.533
6 15.057 36.268 26.286 22.389
7 11.963 36.263 26.181 25.592
8 9.236 36.653 26.130 27.981
9 6.949 37.643 26.448 28.959
10 5.319 38.377 27.209 29.095
Variance Decomposition of TOT
1 0.000 0.000 0.000 100.000
2 1.168 0.630 3.083 95.118
3 1.957 1.587 2.303 94.153
4 2.009 3.424 1.512 93.055
5 2.005 4.918 2.050 91.027
6 3.000 5.751 2.851 88.398
7 3.969 6.021 3.113 86.897
8 4.928 6.036 2.961 86.076
9 6.884 6.002 2.714 84.400
10 7.847 6.033 2.511 83.609
Source: Authors’ estimation.
 Terms of Trade and Volatility: China 25

17.89% by its own innovation; 36.67% by innovations of labor; 25.91% by

innovations of capital; and 19.53% by innovations of terms of trade. In period
10, the shocks in economic growth are caused 5.32% by its own shocks,
whereas 38.38% are caused by innovations of labor; 27.21% by innovations
of capital; and 29.10% by innovations of terms of trade.
The shocks in terms of trade are caused 100.00%, 95.12%, 91.03%, and
83.61% by its own innovations in periods 1, 2, 5, and 10 respectively. The
shocks in terms of trade are 0.00%, 1.17%, 2.00%, and 7.85% by innovation
of economic growth in period 1, 2, 5, and 10 respectively. These findings
suggest the unidirectional causal relationship between terms of trade and
economic growth in China runs from terms of trade to economic growth.
Table 15 represents the results of variance decomposition analysis of vola-
tility of terms of trade model.
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Results of Table 8.2 show that in the first round the change in economic
growth is caused completely by its own innovations. In the second period,
93.70% is caused by its own innovation; 2.51% by labor; 3.34% by capital;
and 0.45% by terms of trade. In period 5, the shocks in economic growth
are caused 67.67% by its own innovation; 18.85% by innovations of labor;
3.81% by innovations of capital; and 9.67% by innovations of terms of trade.
In period 10 the shocks in economic growth are 35.49% by its own shocks,
whereas 21.23% are caused by innovations of labor, 25.87% are caused by

TABLE 15 Results of Variance Decomposition Approach of Volatility of Terms of Trade

Period GDP LAB CAP TOT

Variance Decomposition of GDP

1 100.000 0.000 0.000 0.000
2 93.702 2.507 3.337 0.453
3 86.111 7.943 4.173 1.772
4 76.976 14.230 3.919 4.875
5 67.668 18.851 3.813 9.668
6 60.673 20.924 4.117 14.286
7 52.469 21.529 8.785 17.217
8 48.601 21.587 11.471 18.341
9 44.651 21.363 15.836 18.150
10 35.490 21.227 25.871 17.413
Variance Decomposition of TOT
1 1.424 11.355 22.283 64.938
2 8.291 15.736 17.468 58.504
3 12.824 17.467 13.269 56.441
4 13.229 18.361 11.976 56.434
5 11.169 19.808 12.700 56.323
6 11.769 21.783 13.527 52.922
7 16.585 24.028 13.045 46.342
8 21.337 26.637 11.826 40.200
9 23.450 29.324 10.768 36.459
10 23.609 31.530 10.121 34.741
Source: Authors’ estimation.
 26 S. T. Jawaid and S. A. Raza

innovations of capital, and 17.41% are caused by innovations of terms of

trade.
The shocks in terms of trade are 64.94%, 58.50%, 56.32%, and 34.74% by
its own innovations in period 1, 2, 5 and 10 respectively. The shocks in terms
of trade are 1.424%, 8.29%, 11.17%, and 23.45% by innovation of economic
growth in period 1, 2, 5, and 10 respectively. These findings suggest the bidir-
ectional causal relationship between volatility of terms of trade and economic
growth in China.

CONCLUSION AND POLICY RECOMMENDATIONS

This study investigates the effect of terms of trade and its volatility on econ-
omic growth of China by using the annual time series data from 1980 to 2010.
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Autoregressive distributed lag (ARDL) cointegration, and Johansen and Juse-

lius (1990) cointegration methods suggest the significant negative long-run
relationship between terms of trade and economic growth. On the other
hand, negative and significant long-run relationship exists between volatility
of terms of trade and economic growth. Different sensitivity analyses are per-
formed to test the robustness of initial results by using different additional
variables, various proxies of volatility of terms of trade, dynamic ordinary
least square (DOLS), and fully modified ordinary least squares (FMOLS).
All sensitivity tests indicate that initial results are robust. Results of CUSUM
and CUSUM square estimations suggest that there is no structural instability
in the residuals of equation of economic growth.
It is concluded that less volatile terms of trade are better for economic
growth. Policy makers should critically analyze the reasons of deterioration
of terms of trade in years from 1985 to 1988, 1994 to 1995, 1998 to 2002,
and from 2006 to 2008. This deterioration happened because of an increase
in import price or a decrease in export price or because increase in export
price is less than increase in import price. This analysis will be beneficial to
find the contents of export and import by which terms of trade deteriorate
and form growth-enhancing policies. At this stage, we can also set the
direction of future research in that the relationship between group-wise
and bilateral terms of trade with economic growth should be analyzed.
These results would be helpful for policy makers of China to frame
growth-enhancing country-wise policies as well as commodity-wise trade
policies.

NOTES

1. For cross sectional studies, see Bleaney and Greenaway (2001) Cashin and McDermott (2002a;
2002b) and Jawaid and Waheed (2011) and for time series studies, see Fatima (2010) and Wong (2004,
2010).
2. Hye (2012); Shahbaz, Islam, & Aamir (2012);Wong (2010).
 Terms of Trade and Volatility: China 27

3. See Prebish (1950) and Singer (1950).

4. See Harberger (1950) and Laursen & Metzler (1950).
5. The core countries are the industrialized countries that had rising terms of trade throughout the
seven decades and the periphery had no rise and experienced long-run decline.
6. See Jawaid & Waheed (2011); Jawaid & Raza (2013); Kohpaiboon (2003), Wong (2004).
7. See Balasubramanyam et al. (1996); Barro (1999); Kohpaiboon (2003).
8. The web link of data source is http://data.worldbank.org/indicator.
9. Bleaney and Greenaway (2001) and Amber and Waheed (2011) have adopted the same method
for measurement of volatility. Also see Gujarati and Porter (2008), pp. 796–798.
10. See Dickey and Fuller (1979).
11. See Phillips and Perron (1988).
12. See Pesaran and Shin (1999).
13. Haug (2002).
14. Pesaran and Shin (1999) and Pesaran et al. (2001).
15. To check the short-run relationship we employed the error correction model developed by Engle
and Grange (1987) but the results were insignificant.
16. See Fatima and Waheed (2011).
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17. See Goel and Ram (2001).

18. Bum and Jeon (2005).
19. See Hansen (1995); Phillips and Hansen (1990).

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