The invisible hand

Why Argentina needs free trade more than ever  |  There is little doubt that Argentina needs a miracle, or at least a helping hand. No, this is not another reference to football: just a simple statement of fact.

It has until the 30th July to find USD 1.3bn in order to avoid default. Argentina’s trade performance has suffered as a result of poor economic and trade tariff management since 2011. Trade declined in 2012 by over 4% and while it grew in 2013 and is expected to return to growth of around 7% this year, this will only take it back to the levels of exports last seen in the middle of 2011. Policy makers have focused instead on attracting inward investment to develop the large shale gas reserves, taking their eye of the trade ball. Yet even this policy has stalled: Delta Economics is forecasting that Foreign Direct Investment levels will increase in 2014 but this will again only take them just above the 2011 levels. Put simply: if Argentina is to stave off the permanent threat of default and encourage enduring FDI, it will have to bring the invisible hand back into its trade markets.

At first glance, it does not appear that trade matters unduly to the Argentinian economy. It still runs a trade surplus, although not as substantial as it was and this is reflected in its positive terms of trade (the value of exports in relation to the price of imports). Yet there appears to be very little correlation (-0.37) between its terms of trade and the value of the Argentinian Peso (ARS), as illustrated in Figure 1.

 

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Figure 1  |  Argentina’s terms of trade vs ARS per USD, Last Price Monthly, June 2001-June 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

This matters in so far as countries with high correlations between trade and their currency values are less prone to speculative attacks on their currency. The Peso has weakened by around 50% since the financial crisis: the last time the deterioration in its value was as substantial, Argentina was gripped by its last sovereign debt crisis. While the decline in value has been over a longer period of time, it does suggest that traders are speculating against Argentina being able to re-pay its debt.

If this is the case, then it is more than worrying. Argentina needs to default on its debt a bit like its football team needs the Netherlands to score 2 goals in the first fifteen minutes of the game on Wednesday. If it defaults, then it will find it very difficult to raise the external capital/inward investment that it needs to begin the process of extracting shale gas. But as Figure 2 shows, Argentina is no longer a net exporter of oil and gas, so, in order to restore its self-sufficiency urgently needs this inward investment.

 

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Figure 2  |  Value of Argentina’s oil and gas trade (USDm) versus ARS per USD, Last Price Monthly, June 2001-June 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

The Peso is barely correlated with oil and gas exports (-0.42), although it is correlated with its imports (0.72) suggesting that as the currency weakens (values are in Peso per USD), it is more likely to import oil which is worrying because it suggests that oil imports are plugging a structural weakness in Argentina rather than a response to imported oil being proportionately cheaper. And as the correlation with exports is so weak, it reinforces the view that the currency is more closely correlated with its economic condition than with its trade position.

So what is the scale of the challenge ahead? What does the Argentinian government need to do if it is indeed to create substantial economic growth through the inward-investment associated with shale gas production? Figure 3 presents the specific six-digit subsectors within natural gas that represent shale.

 

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Figure 3  |  Value of Argentina’s natural gas imports and exports (USDm), 2001-2026 (forecast)

Source  |  DeltaMetrics 2014

 

Other things being equal, that is, if inward investment continues at the pace we are currently seeing it and if policy and the economic climate remain unchanged, then the picture is not rosy for Argentina’s shale gas revolution. Our model suggests that imports are already outstripping exports and that trend will continue to grow over time. The chance of a trade surplus is remote, as is the chance of self-sufficiency in gas.

It is not the intention to enter a debate on shale in Argentina, still less to suggest that this is the only way out of the current crisis. Instead, just take a look at where policy really can have an influence: trade. Argentina’s openness, in other words its trade as a proportion of GDP has grown from just under 30% in 2001 to over 60% now. The economy is more dependent on trade as a result since it is so important in relation to GDP.

Yet oil and gas is not the sector, arguably, where it should be focusing in the short term. There are two reasons for this. First, the normalised revealed comparative advantage of oil and gas has deteriorated from a position where it was competitive in 2001 (0.39) to a position where it is uncompetitive now (-0.51). We are expecting its position to deteriorate still further to -0.60 by 2020. In contrast, Automotives were uncompetitive in 2001 (-0.12) but are competitive now (0.32) and will be more so by 2020 (0.38).

Second, there appears to be a much stronger correlation between automotive trade and the value of the currency suggesting that some of the speculation may dissipate if the manufacturing side of the economy can be allowed to flourish as Figure 4 shows.

 

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Figure 4  |  Value of Argentina’s automotive exports overall and to Brazil (USDm) vs ARS per USD, June 2001-June 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

If Argentina can grow its manufacturing sector then it stands a chance of creating real export-led growth, particularly if it focuses on the regional automotive supply chain to Brazil since the correlation between it and its currency is particularly high for that trade route. As the currency has weakened, this has strengthened the position of Argentina’s automotive sector in relation to Brazil and has provided a platform for growth.

This is where policy makers should focus to address the challenges of growth and currency stability in the long run and to provide a clear message to markets and arguably the US Supreme Court to stave off default in the short run. Trade suffered between 2001 and 2012 when tariffs were first imposed and Argentina can in no sense afford to make this mistake again. Free trade is as key – otherwise the “hand of God” may well start to look like an Argentina own goal.

 

 

Own Goal?

Why Brazil needed to think beyond winning the World Cup on home turf  |  That Brazil might not be in the World Cup final on July 13th is to many Brazilians and football pundits around the world unthinkable. It is a shame that similar confidence cannot be applied to the Brazilian preparations for the World Cup or, indeed to the Brazilian economy more generally. Brazil, in the words of a German trade agency official, is the country that is “always going to promise growth just around the corner”.

Take Foreign Direct Investment (FDI) as an example. Since its peak in 2008 to the end of 2014, Delta Economics anticipates that it will have grown by just under 20% in nominal value terms despite the World Cup, the need for infrastructure around newly found oil reserves and the promises of a Latin American automotive hub. This includes a drop of 45% between 2008 and 2009, a subsequent 66% recovery and then growth of just 0.6% in 2012. Delta Economics anticipates that the forecast 6.8% growth in FDI this year will be nearly 1% lower than growth in 2013. Combined with flatter growth, high inflation and high interest rates, it is small wonder that the failure of the economy to deliver growth has frustrated investors as much as the failure of the World Cup to delivery prosperity has frustrated people.

The reason why interest rates are so high is not just to keep inflation under control, it is also to keep the value of the Real from tumbling. The Real-USD spot price is negatively correlated (-0.69) with Brazil’s total trade: after all, Brazil’s potential is defined by its capacity to become the Latin American growth engine with both natural resources, energy and manufacturing capacity to fuel its trade surplus (Figure 1).

 

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Figure 1  |  Brazil’s total trade (USDm) June 2001-April 2015 vs Real per USD, Last Price Monthly, June 2001- April 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

Except for the period during the financial crisis the value of the Real rose with trade consistently to the middle of 2011 but has slipped back against the US Dollar since then. Trade has similarly slipped back since then. What this suggests is that the currency is driven by increases in trade because investors see this as a route to growth in the economy and therefore returns. The currency itself has not necessarily influenced trade itself: as the currency has strengthed, so has trade, although, as a surplus nation, it might be expected that Brazil’s exports in particular would drop of with a strengthening currency.

By way of confirmation that there is a large speculative element in Brazil’s currency valuation, its Terms of Trade are not particular correlated with the value of the Real (Figure 2), but they are highly correlated with the oil price (0.89).

 

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Figure 2  |  Brazil’s terms of trade (value of exports in terms of the value of imports), June 2001-April 2015, vs Real per USD, Last Price Monthly, June 2001-April 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

What this suggests is that neither export nor import growth is particularly influenced by the value of the currency. This is because of the strong speculative element to the value of the Real which means that investment has little connection with the economic fundamentals in the economy – only its potential. The correlation with the oil price is unsurprising because it simply reflects the dominance of oil in Brazil’s trade structure.

And this structure of trade has changed little over the last 12 years. The Finger-Kreinin Index (FKI), which compares the structure of trade in one country against others, suggests that while other BRIC countries have become more like Brazil, Brazil itself has failed to capitalise on its manufacturing potential seen a decade ago in its car sector.

In the context of an imminent World Cup tournament, the irony that the Brazilian car sector is dominated by German manufacturers is not lost. As Figures 3 and 4 show, Brazil’s exports to Germany are most strongly correlated with the value of the Real of all its top five export partners. This is simple to explain: exports to the Netherlands are largely in oil, to the US are in Maize and Oil, to Japan in iron ore and oil and to China in iron ore, oil and soya.

 

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Figure 3  |  Correlation of Brazil’s exports to its top five export partners with Real per USD, Last Price Monthly, June 2001-April 2014

Source  |  Delta Economics analysis

 

Why should exports to Germany be more correlated with the value of the Real (Figure 4)? Perhaps it is because of the potential in that trade relationship: inward investment from German manufacturers has promised much for Brazil: innovative automotive production plants with a strong supply of automotive components from Argentina were regarded as the engine of a competitive nation that could move from being highly commodity dependent to one that could skip the intermediate manufacturing seen in other BRICs and focus on high-end automotives. Anticipating the

 

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Figure 4  |  Value of Brazil’s exports to Germany (USDm), June 2001-April 2015 vs Real per USD, Last Price Monthly, June 2001-April 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

But Germany is Brazil’s fifth largest export destination and although the relationship has promised much, reflected in the high correlation it has disappointed investors, hence the pressure on the Real now.

Brazil is an increasingly open economy with trade anticipated to account for 46% of GDP in 2014 rising to 52% in 2018. However, this reflects two things in our forecast: flatter projected GDP and the dominance of commodities in its structure of exports in particular (Figure 5). While there is evidence that Brazilians are increasingly demanding more sophisticated products (automotive imports are forecast to grow 14% in 2014 while bio-pharmaceuticals are forecast to grow by nearly 12%, for example), the fact that two of the fastest growing import sectors are printing and ancillary machinery and telephone equipment suggests that infrastructures are still growing at catch-up rates.

 

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Figure 5  |  Where is the infrastructure?

Source  |  DeltaMetrics 2014

 

If Germany is the country amongst Brazil’s top importers that has the most to offer in terms of higher end export potential then Figure 5 also presents a more worrying picture. The fastest growing import sectors from Germany into Brazil do not reflect infrastructure development, but do reflect greater consumer demand for telephones, air-conditioning, medicines and medical equipment. The largest import sectors from Germany are similar: cars, medicines, car parts, fertilisers and biopharmaceuticals. Out of the fastest growing import sectors from Germany, the ones most correlated with infrastructure rank 25-30: pumps, car parts, machinery related to rubber and plastic processing, lifting & handling machinery and internal combustion engines.

It is not the place of an economist to predict who is going to be in the World Cup final, still less to predict might win it. But consensus (measured through the odds) of a Brazil-Germany final is not out of the question. Brazil must hope that, if this happens, it can avoid the own goals that have plagued the infrastructure and trade development since it was announced as the host nation for the 2014 tournament.