BRIC through a window

Why Russia’s attempt to decouple from the dollar is a defensive strategy  |  Gazprom’s decision to price oil trade with China in Roubles or Yuan rather than US Dollars effectively demonstrated the power that the BRIC countries want to exert over world trade. It has profound implications for trade finance, not least because a cry for decoupling emerging currencies from their dollar-dependency resounded across emerging Asia, and France, last week. The issue is that, as global pressure on interest rates in the US build and as tapering continues, the threats to Emerging Economies of US Dollar-denominated debt increases. It has not been a great year so far for Emerging Market currencies and the signals for a stellar recovery in the second part of 2014 are not strong.

France worries about this because of its increasing reliance on countries like Brazil for oil, and perhaps because it wants to bang the drum for the Euro. But Russia’s decision is arguably a defensive one – it is protecting its own oil trade interests with China as its relationships with Europe and the US become more strained. The value of the Rouble against the US Dollar is barely correlated with world trade, Chinese trade or even the oil price and, as a result, it is seeking to integrate itself into the world trade system through closer ties with China. The effect will be the strengthening of the Yuan, and ironically the Euro, as trade finance currencies and while it might serve to weaken the hegemony of the US Dollar in trade terms, it will have little impact on the value of the Rouble.

The reason for this is simple. There are two currencies that are very strongly correlated with world trade: the Yuan and the Euro, as shown in Figure 1.

 

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Figure 1 | World export trade values (USDbn) versus USD-Yuan, Last Price Monthly, June 2001-June 2014
Source | DeltaMetrics 2014, Bloomberg

 

The correlation between the value of the Yuan and world exports is -0.91: in other words, as it weakens against the US Dollar, world exports increase and vice versa. This is of little surprise to any observer of world trade: the Yuan is a managed currency and it has been a bone of contention in trade negotiations between the US and China that its artificial weakness has kept Chinese exports strong. Indeed, as the currency has been allowed to strengthen over the past couple of years, world trade has slowed. This is not just simply a reflection of the dominance of Chinese exports in world trade. China’s trade is highly currency elastic – it exports intermediate manufactured goods that are very price sensitive and so trade will also be highly influenced by the value of its currency.

But there is more than just global trade at stake from Russia’s point of view. Russia needs to secure markets for its oil exports if it is to undermine the effects of first, any sanctions that may arise from the continuing crisis in Ukraine and second, the reduced dependency of Europe on Russian oil and gas. Its obvious trade partner is China and, indeed, Russian exports of oil and gas to China are forecast to grow annually by around 9% each year to 2020. China is resource hungry and, as a result, its trade is highly correlated with the oil price as well as with the value of its currency, as illustrated in Figure 2.

 

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Figure 2  |  Value of Chinese exports versus NYSE Arca Oil Spot Last Price Monthly, June 2001-June 2014
Source | DeltaMetrics 2014, Bloomberg

 

The Rouble-Yuan currency spot is highly correlated with Chinese trade (0.75) and this potentially helps to explain why Russia is so interested in building up the ties between the two currencies through oil trade in particular. It strengthens the likelihood of the Yuan increasing its importance as a currency for trade finance and protects Russian trade interests against the weakness of the Rouble-USD exchange rate in other markets.

The only other currency where the correlations with Chinese trade, world trade and oil are as strong is the Euro, as Figure 3 suggests.

 

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Figure 3  |  Correlations of major currencies with world exports, Chinese exports and the NYSE Arca oil spot price. June 2001-June 2014
Source  |  Delta Economics analysis, 2014

 

Apart from the strong correlations with trade and oil prices of the Yuan-US dollar price, the table also shows how important the Euro is as a trade currency. Past trade views have commented on the fact that the Euro is a trading currency that responds to economic fundamentals and not a currency that is used for speculation. Russia’s move towards the Yuan and away from the dollar will not strengthen the rouble, since its value against the dollar is barely correlated with trade and only weakly correlated with oil prices. However, it could serve equally to serve the purpose of strengthening the Euro as a trade finance currency.

The reason for this is because of the strong correlation between the Real-USD value and both world trade and Chinese trade and the oil price. While not as strong as the Euro value alone, there is something important that is emerging in terms of Brazil’s role in the trade finance system. Brazil’s exports to China are forecast to grow at above 11% for the next four years, and much of this trade is commodity-based – soya and oil in particular. Similarly, France’s imports of oil and gas from Brazil, for example, are set to increase in double digits annually over the next five years and exports to Brazil from Europe are forecast to grow at similar rates to exports to China over the next five years.

This helps to explain, perhaps, why there was a call from France in the last week to loosen ties with the US Dollar as well. Figure 4 shows that France’s trade is, in comparison with German trade, weakly associated with the value of the Euro versus the USD.

 

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Figure 4  |  Correlations of key currencies against French and German exports, June 2001-June 2014
Source  |  Delta Economics Analysis, 2014

 

Perhaps more importantly, French exports are more correlated with the value of the Yuan versus the US Dollar, albeit more weakly than German exports. A logical conclusion is that it is in the interests of all exporters from the Eurozone for the Yuan to be a more dominant trade finance currency as it will help their trade, and hence the value of the Euro.

Russia’s move away from the US Dollar has a deep resonance across the trade finance system. First, it will encourage the Chinese government to decouple the currency from the dollar and allow it to trade in currency markets more freely which, in and for itself has to be a good thing for the global trading system. Second, it means that trade, and hence trade finance, will increasingly be denominated in Yuan, and arguably Euros as well, reducing the importance of the Dollar as a trade finance currency. Again, this is welcome on the grounds that it supports free trade.

And third, given the fragile relationship geo-politically between Russia and the US at the moment, it also makes it more important that the US engages in trade talks with Asia. If the Yuan and the Euro become more important as a trade finance currencies, then the US cannot afford to be isolationist in the way it handles its trade negotiations. Whichever way this is looked at, Russia has just thrown a BRIC through the window of the US’s current trade stance.

Webcast 016 | Whisky and aspirin: is this the future of Europe?

In light of Delta Economics negative forecast for European growth, CEO Rebecca Harding and OMFIF Founder David Marsh explore the reasons behind the slowing in trade and how it is affected by, amongst other things, the recent slowing in Asian markets and uncompetitiveness. The discussion also examines the internal imbalances in the European economy, with particular emphasis on Germany and also looks at some of the fundamental differences between countries such as Greece and Spain with a view to understanding differences in trade growth patterns. This webcast also discusses the relatively positive trade growth in European periphery economies as well as they challenges they will face in the short and longer term.

 

Webcast 016 Author  |  Rebecca Harding  |  CEO

Be wary what you wish for

Why the anti-European protest movement is missing the point | As the dust settles from last week’s European Elections one thing will be quite clear: there is a real momentum behind anti-establishment and Euro-sceptic protest parties across the continent.  From the “Alternative für Deutschland” (AfD) party promoting Germany’s exit from the Euro, through the Front Nationale in France, to UKIP (UK Independence Party) advocating the UK’s exit from Europe altogether, the mistrust in established politicians is manifest.  Beyond the clear fact that voters are frustrated with national politicians, the core of Euro-sceptic sentiment is rooted in anger, indeed frustration, at the failure of Europe’s politicians to create economic security for its voters because of the tortured recovery from the financial and sovereign debt crisis, perceived threats to job security from immigration and a failure of European institutions more generally.

As Europe and the UK’s mainstream politicians start to re-calibrate their dialogue with the electorate about Europe, they would do well to focus on trade, not least because one of the two founding principles of the European Union was free trade between Member States.

Trade is central to understanding why European Union is important.  First, take the country with the most vocal advocates of European exit, the UK.  Trade with Europe was worth an estimated £301bn to the UK economy in 2013 and the Centre for European Reform (CER) estimates that some 30% of the UK’s total trade is reliant on membership with the EU.  Second, there are signs that economic conditions in Europe are improving: our forecast for European trade has risen from a negative forecast for 2014 three months ago to a flat growth forecast (-0.08%) now reflecting an improvement in underlying drivers of trade included in Delta’s model, including lower market volatility, improved GDP and greater migration which improves the downward pressure on trade of aging populations.

Europe remains a long way from sustained growth, still less rapid growth, but there are positive signs of internal rebalancing since Mario Draghi’s commitment to “do whatever it takes” to ensure that the Euro did not collapse.  But while Mr Draghi concentrated on the need for the ECB to shore up the Euro as required, the Delta Economics view is that Europe’s longer-term solutions lie in its international competitiveness represented through its external trade balance.  Figure 1 shows why we see this as the case.

 

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Figure 1 | The Value of EU 28 and Eurozone trade (USDm) versus the USD per Euro exchange rate, Lat Price Monthly, June 2001-April 2014

 

What is remarkable about the relationship between the value of Europe’s and the Eurozone’s exports and the USD-Euro currency spot price is the strength of the correlations: 0.86 NS 0.87 respectively.  In itself, this helps to explain why, even at the depth of the sovereign-debt crisis there was never a serious or sustained run on the Euro.  The currency is a trade currency and this means that it is less vulnerable to speculative volatility.

Similarly, European markets are also highly correlated with EU28 and Eurozone trade.  Taking the DAX as a proxy, the correlations are 0.76 and 0.75 respectively, as illustrated in Figure 2.

 

 

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Figure 2 | The value of EU 28 and Eurozone Exports (USDm), June 2001-Dec 2016 versus the DAX Last Price Monthly, June 2001-April 2014

 

Figure 2 shows a weaker correlation with the value of the Euro since mid 2011 for the Eurozone reflecting the sovereign debt crisis, the relationship between  EU 28 trade and the value of the Euro has remained strong, suggesting that the DAX reflects the economic fundamentals of trade to a greater extent than does, say, the FTSE 100.

Figure 3, which shows the relationship between the value of the UK’s exports to the EU and shows that, although the relationship is weaker (correlation of 0.69) the UK’s trade relationship with Europe is an important driver of market sentiment.

 

 

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Figure 3 | Value of UK exports to the EU (USDm), June 2001-Dec 2016 vs FTSE 100 Last Price Monthly, June 2001-April 2014

 

What all this suggests is that the value of the Euro and key European stock markets are highly linked with European trade generally and UK trade with Europe in particular.  The UK’s trade with Europe is even reasonably correlated with the value of the DAX at 0.64.  In other words, markets can use trade statistics as a proxy for underlying fundamentals and react accordingly. Indeed, unlike the S&P 500, which appears to have gone in the opposite direction to trade recently, European markets seem to reflect European trade quite closely.  The conclusion? That Euro-sceptic political parties do not need to worry as much as they thought about economic mismanagement if a focus on long term growth, competitiveness and trade can supersede the shorter-term focus on austerity and rebalancing over time.

During the course of the next year, however, Europe’s politicians need to worry about the consequences of a potential UK exit from Europe, following the proposed referendum should the Conservatives win the next election.  The debate will focus around the benefits to the UK of European membership and a cursory look at the correlations between the USD-Euro, Sterling-Euro and Sterling-Dollar spot prices confirms that the value that the UK extracts from its EU in currency terms is far less than the value that the EU gets from its trade with the UK.

 

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Figure 4 | Why Europe matters to the UK
Source | Delta Economics (Estimated proportion of trade dependant on EU – Centre for European Reform)

 

The correlations are much stronger between UK trade with Europe and the value of the Euro than they are for the value of Sterling, particularly against the Euro where the correlation is minimal.

This is hardly likely to have an impact on the average British voter, however, and, far from suggesting that the UK’s trade with Europe is valueless in currency terms, the fact that the correlations are weaker simply illustrates how the value of Sterling is more volatile in response to market sentiment rather than economic fundamentals.  Actually, as Figure 4 suggests, the value to the UK economy of trade with Europe is significant and, if the UK were to exit from the EU then the country would lose some £425bn, or over £6,000 per head of population in lost export trade value by 2022.

More than this: our forecasting model suggests that trade is highly correlated with skills, at some 0.98 across key countries in the European Union, the US and India.  In other words, across the developed and the emerging world, higher skills lead to more trade.  Here the UK has a gap with its European competitors: the skills component of trade is actually mildly negatively correlated with trade itself at -0.30 where it is 0.98 in other European countries.  In other words, the bulk of UK trade is currently not skills dependent and on the face of it may actually benefit from having lower skills (and hence lower costs) associated with it. Similarly innovation is only mildly positively correlated with UK trade at 0.35.

Two other countries with skills and innovation correlations like this are Brazil and China suggesting that the UK could easily lose out to lower cost nations if the bulk of its trade remains at this lower value end unless it can find cheaper ways of producing the same goods. Reports in May suggested that migration may actually have a positive effect on trade by reducing costs.

But there are two significant issues with assuming a low cost-low skill trade base for the UK is adequate. The first is one of principle: the UK should remain competitive at the higher value end of goods trade where innovation and skills are highly correlated with trade and where cost is less important. It is imperative that it increases the innovation component of its trade and recruits people with the skills to work in an innovative and international environment.  The second is one of practicality: if the UK is to find the people to take these roles, then it will have to compete with the rest of Europe as well as emerging economies like India which have high correlations of trade with skills and innovation. Accessing wider skills and innovative capacity through immigration is a central pillar of a strategy to build high-end competitive.  For example, Germany, having identified skills shortages in its productive and exporting base a decade or longer ago, now has its highest net-migration since 1993.

If Europe’s economy is improving, the benefits of trade to individual member states so great and the benefits of migration in skills and innovation terms so clear, Eurosceptics would do well to remember to be wary what they wish for.

 

Even a stopped clock….?

Why economists are right to be cautious about the recovery | In a recent after-dinner speech at an Economists’ event I attended, a senior UK economist and a former external member of the Monetary Policy Committee explained why economists are cautious about stating unequivocally that the recovery in the UK and Europe has started. The argument ran something like this: first, economists generally as a profession did not predict the downturn; second, although there are plenty of individuals who will state that they knew it was coming, it was not predicted in our models and therefore we should be wary of declaring recovery – just in case everything collapses again; third, there are plenty of signs that any recovery in 2014 is weak and is unlikely lead to global “escape velocity”, as Christine Lagarde, the Head of the IMF reminded us last week.

As the World Trade Organisation (WTO) looks back into its crystal ball on the 14th April, tells us what happened to merchandise trade in 2013 and revises what it thinks will happen in 2014, it would do well to remember the humility with which all economists should treat any forecast. In a sense, its job is easy. It is revising its forecasts for 2013 and therefore 2014. It is likely to come in at a trade growth figure for 2013 around 1.9% in contrast to its forecast of 2.5% for last year. This will mean that it will also have to revise downwards its forecast for 2014 as it will be starting from a lower base but, because it is using the more optimistic assumptions modelled by the IMF of faster growth in developed countries, it will still be very optimistic on trade growth for the year.

Delta Economics’ own estimate of trade growth in 2013 suggests that trade growth has been lower than the 1.9% that the WT0 was informally predicting back in December at just 1.4% averaging out imports and export growth. Our modelling is based on the monthly IMF Direction of Trade Statistics, the United Nations Comtrade Statistics and 93 national statistics offices. The first two are the same datasets that the WTO itself uses, the third harmonises the data with national data to bring it up to date.

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Figure 1 | Delta Economics Q1 2014 World Trade Forecast overview

Figure 1 Source | DeltaMetrics 2014

Given that the data is similar to that used by the WTO, it is hard to see why it would come in with a value as high as 1.9%, but estimating techniques vary and the figure of 1.5% growth in imports in 2013 without a correction for global disinflation may explain the difference.

However, what matters more is the fact that the Delta Economics forecast for world trade growth in 2014 has been falling over the past six months and will, no doubt, be several percentage points below that of the WTO’s which currently stands at 4.5% for 2014. While, like the WTO/IMF’s forecasts, we saw more buoyant conditions at the end of 2013 but even so, the moving average forecast over the past 6 months suggests that world trade growth in 2014 will be only just above 1% compared to 1.5% that we were forecasting in December.

There are several reasons why Delta Economics is cautious about predicting a rapid expansion in trade growth this year. The first is that, as Figure 1 suggests, while we are more positive about the US, Germany and the UK, we are more negative or neutral about exports from other top trading nations: China, France and Japan. Our forecasts are also more negative for other, key, economies such as Canada, Mexico, India, Saudi Arabia and the UAE. This leads us to have a generally more negative outlook for export growth in every region except Europe and for Europe we are forecasting a slightly slower contraction rather than growth.

The second reason why we are less positive about trade is because of the patterns of trade between developed and emerging economies. The main feature of the post-crisis recovery was a more rapid recovery of emerging economies in trade terms compared to developed nations, shown in Figure 2.

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Figure 2 | North-North and South-South trade, June 2001-Dec 2016 (USDbn values)

Figure 2 Source | DeltaMetrics 2014

North-North trade has yet to return to its pre-crisis levels and will remain flat for the next three years according to our forecasts, but more importantly, South-South trade, which drove trade recovery after the downturn globally, will grow by just over 5% in 2014 compared to over 18% in nominal values between 2011 and 2012. And since this is predominantly accounted for by commodities, infrastructure and intermediate manufactured goods, it suggests that these economies will not be demanding the products that fuel growth for the foreseeable future. Declining export forecasts for China, India and Mexico, as well as slower forecast growth in Asia, Latin America and MENA illustrates just how the spillover effects of South-South slowdown work through to these countries.

Some of the fall in prices is because of how trade is measured. We, like the IMF and the WTO, use US Dollar nominal values to create our trends but what this does, is illustrate very clearly that if there has been downward pressure on prices this, in and for itself would explain why we are showing slower actual growth. The current price forecasts that Delta Economics models, effectively show how trade volumes will be affected if prices remain the same. On the basis of this, we are forecasting only modest growth in South-South and flat growth in North-North trade volumes.

Why this is important is because of the effect that it has on equity markets in particular. For example, the BSE Sensex is highly correlated with South-South trade (0.92) and this is illustratively presented in Figure 3.

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Figure 3 | South-South trade and the Indian BSE Sensex last price monthly, June 2001-Feb 2014

Figure 3 Source | DeltaMetrics 2014

When equity prices generally fell between 2007 and the end of 2008, the subsequent lock-down in credit affected markets for trade finance with the result that South-South trade fell as well after a time-lag. The upward trend of the market and emerging world trade continues until the end of 2010 when again, a drop in the market created uncertainties, particularly about India’s trade and economic performance and again led to a drop in trade after a four month time lag.

And this matters at a global level as well. Figure 4 replicates the same diagram for the S&P 500 and world trade.

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Figure 4 | S&P last price monthly and value of World trade, USD bn, June 2001-Feb 2014

Figure 4 Source | DeltaMetrics 2014

Since 2001, equity prices and trade have been highly correlated. In 2008 we saw a major drop in equity prices and the simultaneous lock-down of credit. What this did was restrict access to trade finance with the consequential 23% drop in trade that we saw in 2009. They moved together with a high positive correlation up to April 2011 reflecting general confidence in markets, but, since then, the relationship has been an equally strong negative correlation.

What this tells us is that markets have not been reacting to economic fundamentals for the last nearly 3 years but instead are reacting to sentiment and political/geo-political events. This makes them volatile, which, as our modelling demonstrates, increases uncertainty and therefore trade itself. It also suggests that there is a correction due during the course of 2014 if we are to return to the high levels of correlation up to 2011.

There is plenty to worry about in world trade at the moment. It is not like GDP in that it is directly affected by geo-political risk, which often works through trade sanctions and embargoes, and it is directly affected by economic uncertainty because this makes the trade finance environment more difficult and can restrict access to finance for exporters. This in and for itself will negatively impact GDP and economic development through trade.

Given the importance of trade to markets, trade finance and to economies generally, improving the accuracy and timeliness of trade forecasts is vital. Delta Economics is erring on the side of caution in proclaiming a recovery, not because it is insuring itself against the likelihood of a downturn but because the geo-political and deflationary downside risks globally suggest that the trade picture is more negative than is currently being predicted elsewhere. Trade, like financial markets, is internationally inter-dependent – one falls and the other falls too. It is no longer adequate to be like a stopped clock – right twice a day.