Guest Blog | Services trade should be a UK strategic priority

The release of UK balance of payments current account figures for 2014 was greeted by the usual shock horror headlines. The deficit in 2014 was close to £100bn, and reached the highest share of GDP recorded since 1948. Our current account deficit of 5.5% of GDP in 2014 exceeded the previous peaks of 4.4% in 1989 and 3.9% in 1974, after the first OPEC oil price shock.

These headline figures were a bit misleading, however. The underlying trade position for the UK has not deteriorated – for 2014 as a whole the deficit in goods and services was less than 2% of GDP and the figures were on an improving trend through the year. The current account figures reflect some unusually large net outflows of income which could turn out to be a temporary phase.

Digging down further into the trade figures we can find more good news. In 2014, the UK’s exports of services hit a new record – nearly £215bn. The value of UK exports of services is now very close to the total value of our manufactured exports (£225bn). In addition, we run a large trade surplus on services – totalling nearly £86bn last year, nearly 5% of GDP. This trade surplus on services more than offsets our deficit on trade in manufactures (£81bn). Both the level of services exports and the services trade surplus reached new highs in 2014.

Because services trade is less visible than goods trade, its importance tends to be underplayed. The UK is a remarkably successful exporter of services – second only behind the US in the world. Services exports account for around 12% of UK GDP, compared with around 8% in Germany and France, 4% in the US and 3% in Japan.

There are a number of myths about services trade which need to be dispelled. The first is that it is all about selling financial services, and therefore we are overly dependent on the City of London for our successful record of exporting services. In fact, the UK has a very diverse range of services exports. Banking, insurance and other financial services do contribute about a third of the total in the UK. But business and professional activities account for a quarter of our services exports. IT, travel and tourism, education and the creative industries – music, film, design, etc – also make a substantial contribution.

A second myth is that services trade does not add as much value to the economy as manufactures. In fact the reverse is true. Manufacturing industry is a big importer of components , energy and raw materials. So the value-added element of £1 of manufacturing exports is lower than the equivalent in the services industries. Work by the OECD suggests that UK services exports generate more value-added for the UK economy than manufacturing trade, not less.
A third myth is that we have exhausted the growth potential of our exporting services industries. Though services account for 70-80% of the output of major economies, their share of total world trade is just 20%. A concerted approach to breaking down barriers to trade in services – both within the European Union and more widely across the international economy – could support further rapid growth, as a recent report from the CityUK Independent Economists’ Group has argued. A PwC report in 2013 found that emerging market imports of services are now larger than the G7 economies – and were growing three times as fast.

Services trade is a big success story for the UK and services exports have significant growth potential. It is likely that within the next five years, UK services exports will exceed our overseas sales of manufactures. A strategic focus on breaking down barriers to trade in services, and maximising our export potential, should therefore be a priority for the next term of government – whichever party wins the forthcoming General Election.

 

 

Services trade should be a UK strategic priority | Guest Blog author | Andrew Sentance | Senior Economic Adviser PwC

Webcast 033 | Losing interest: why negative interest rates present a challenge to global growth

It has been a tough start to 2015: what will be the outcome of persistently low interest rates be? Rebecca Harding and Sarasin & Partners’ Subitha Subramaniam discuss the topic.

 

Webcast 033 Author  |  Rebecca Harding  |  CEO

Demanding times

Why Europe urgently needs to focus on long term competitiveness  |  The Eurozone has a problem, but not the one that policy makers thinks it has. On the face of it, prices falling by 0.1% between October and November, growth at 0.2% in Q3 and unemployment at 11.5% is quite enough to concentrate minds as ECB policy makers sit down at their next meeting on the 4th December. The ECB is coming under increased pressure to stimulate demand across the Eurozone in order to stave off disinflationary pressures that may result in deflation and hence raise the spectre of the Eurozone becoming like Japan: negative price increases alongside near-to-zero growth.

But the problem is not disinflation, nor even deflation as such. It is long term competitiveness and the policy paradoxes that have taken the Eurozone, and, indeed the whole world to the brink of a low inflation, low growth normality as oil prices continue to tumble.

Within Europe the problem is not the willingness to boost investment through Quantitative Easing (QE) and low interest rates. The ECB is already committed to sovereign Bond purchases for peripheral nations if those nations commit to structural reform, which, while contested by Germany and its Constitutional Court, represents a statement of intent. Alongside the promise for corporate bond and asset backed security purchases, the ECB is clearly in the market for some form of QE alongside negative interest rates if necessary.

The policy paradox is this: the solutions that are currently under discussion are aimed at the monetary side of the Eurozone economy while having the effect of contracting the real, demand, side of the economy. By definition, monetary instruments are being used to shore up the banking sector, to inject financial stability into the system and to reflate the economy by increasing the money supply. The hope is that by creating a financially stable system, credit conditions will loosen and, alongside structural reforms and austerity at a national level, will naturally generate growth over the long –term. But the austerity packages and national structural reforms alongside this flatten demand and therefore the capacity for the policies to work over the long term.

One measure of just how flat demand and of how important the drive for greater competitiveness should be is trade. The picture for Europe does not look good: the value of European exports is forecast to decline outside of the EU by 0.5% in 2015 which is a long way from the robust export-led growth that the region needs. Within European EU28 trade is forecast to decline by 3.5% and Eurozone trade by 3.7% over the next year, as shown in Figure 1 which illustrates imports trade within Europe and into Europe from non-EU countries.

 

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Figure 1  |  Monthly value of intra and extra EU and Eurozone imports (USDbn)
Source  |  DeltaMetrics 2014

 

Imports from outside of the EU are forecast to drop by 1.45%. Much of the drop in imports from non-EU countries has to do with the falling oil prices (Figure 2). 7 out of the top 10 oil importers into Europe are not in the EU28 and as 30% of the EU’s imports in value terms are oil and gas, the link between falling import values and the reduction in oil prices is clear. There is a 94% correlation between EU imports from non-EU countries and the oil price: the flat trade forecast for 2015 therefore, suggests that there may be some small upward correction in oil prices but nothing substantial until the end of Q1.

 

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Figure 2  |  Monthly value of EU imports from non-EU countries, June 2001-Dec 2015 (USDbn) vs NYSE Arca Oil Spot, Last Price Monthly, June 2001-Nov 2014
Source  |  DeltaMetrics 2014, Bloomberg

 

In theory, this helps the EU and the Eurozone because it reduces producer costs and, hence, arguably prices as well. Disinflation, which is simply falling prices, is catalysed by lower oil prices but does not in itself represent anything negative.

Of more concern is the forecast drop in intra regional trade between EU28 and Eurozone countries, which is forecast to fall by 3.5% and 3.7% respectively. Much of this trade is dominated by high-end manufactured goods, for example, automotives, consumer electronics, pharmaceuticals and machinery. If demand for these products is falling (Figure 3) then it suggests a deeper malaise within the system that is triggered by disinflation but leads ultimately to lower demand.

 

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Figure 3  |  Europe’s demand problem
Source  |  DeltaMetrics 2014

 

Europe clearly has a problem: it’s demand for the higher end products that have defined its consumption patterns in the past is falling: demand for cars will fall by around 5% in 2015 and demand for medicines by 2.4% and 0.6% respectively. This matters for the world because, if demand is falling, then Europe has the potential to transmit its lower demand through the trade system to the rest of the world since it accounts for 44% of medicines, 34% of cars and 26% of computer imports across the world.

So if Europe is demanding less, then, accordingly, other countries will see their aggregate demand affected by the drop in trade to Europe as net exports drag further on global GDP. This is reflected in the forecast for European car and medicines exports, both top ten trade sectors for the world, which are set to fall by around 1% in 2015. As EU produced Pharmaceuticals account for 64% of all world exports, and cars for 50%, this suggests a tough year ahead.

All is not lost and the highest end, research-led exports from Europe, aircraft and biopharmaceuticals are set to grow significantly. In other words, the challenge for European policy makers is to ensure that Europe remains competitive at the highest end of the manufacturing supply chain where it already dominates global exports.

It is unlikely that the ECB will consider QE on Thursday and most economists expect any European QE to happen in Q1 2015 at the earliest. Delta Economics is of the view that European long term competitiveness is now a more pressing issue than addressing issues of disinflation. A substantial boost to European and domestic infrastructures, particularly to support high end manufacturing industry, is a necessary counterpart to any austerity measures to bring wayward budgets under control. Any QE at any point will be potentially necessary to stabilise international markets but not sufficient to fuel long term growth.

From Russia with love

Why the collapse of the Rouble matters  |  It might well be that President Vladimir Putin needed more sleep, as he said, and therefore left the G20 Summit early in order to rest on the long plane flight home. The Russian economy’s growth in the third quarter of 2014 was just 0.7% and the Delta Economics forecast for trade growth in 2015 is 3.5% – half the level seen in 2014. Some of the drop in trade values may well be due to lower oil prices but this does not explain the fact that imports are forecast to fall from over 9% growth to 4% growth in 2015. If this were not enough, imports of cars have been flat this year and are likely to shrink by 3.5% next. For so long car imports were a proxy for demand for luxury from a burgeoning middle class; so now, even a long plane flight may be too short to recover from the sleepless nights that President Putin may be facing (Figure 1).

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Figure 1  |  President Putin’s sleeplessness explained
Source  |  Delta Economics

 

The collapse in the value of the Rouble cannot be helping Russian policy makers with their insomnia either. The correlation between trade and the value of the Rouble is very low at just 12% suggesting that the currency’s value is unrelated to trade and economic fundamentals but instead has a strong speculative component. When the Rouble was allowed to free-float in November, the result was an immediate devaluation – suddenly connecting it both with the real economy and with the fact that sanctions are making investors nervous.

In contrast, the value of the Moscow MICEX is highly correlated with trade (Figure 2), which helps explain its relative resilience to the battering that the Rouble is currently receiving. Russian export growth, this year at least, remains relatively strong and while this is the case, it can be expected that the MICEX will remain strong too.

 

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Figure 2  |  Monthly value of Russian exports (USDm) vs MICEX,
June 2001-October 2014, Last Price Monthly
Source  |  DeltaMetrics 2014, Bloomberg

 

Unsurprisingly, Russian exports are 94% correlated with the price of oil (Figure 3). This fact points to two dangers for the world economy.

 

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Figure 3  |  Monthly value of Russian exports (USDm) vs NYSE Arca Oil Spot,
June 2001-October 2014, Last Price Monthly
Source  |  DeltaMetrics 2014, Bloomberg

 

First, the decline in oil prices itself will cause the value of Russian exports to fall further which at least in part explains our lower trade forecast for 2015. This is bound to have a weakening effect on the Russian economy. Even the effects of strong oil and gas deals with China, which amount to a doubling of trade over the next five years cannot negate lower prices. More than this, China’s growth in mineral fuel imports is forecast to slow from above 11% in 2014 to just above 8% in 2015 and 2016. Russia’s trade growth is increasingly dependent on Chinese imports of fuels – and if these are growing more slowly, then this does not augur well for Russia.

Second, if Russia’s demand for luxury goods is declining then it is bound to have a negative effect on Europe. Figure 4 shows the effects of the fall in Russia’s demand for cars generally on Germany’s exports of cars in particular.

 

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Figure 4  |  Monthly value of German exports of cars to Russia, USDm, vs DAX Index,
June 2001-Oct 2014, Last Price Monthly
Source  |  DeltaMetrics 2014, Bloomberg

 

So any demand crisis in Russia comes back to affect Europe: the fall in German exports is forecast to continue after a brief respite at the end of Q1 2015 well into Q2 and Q3 of 2015 and, as German car exports to Russia are more than 83% correlated with the value of the DAX Index, this has the potential to create greater instability on European, indeed global, markets The Euro may also experience some fallout as well: German car exports to Russia are 60% correlated with its value.

From a Russian perspective it made sense to form deals with China given the vulnerability both of its own economy and of its relationship with Europe in the wake of the Ukraine crisis. However, there is a perfect storm brewing: a drop in oil prices and a drop in Chinese demand for mineral fuels which could threaten the Russian economy even further than it is currently threatened by sanctions.

There was very little panic on markets around the drop in the value of the Rouble. This is not surprising –the rouble has not been connected with economic fundamentals and it is now so some correction could be expected. But a weaker Russia matters for Europe because of the risks of contagion: the German export engine is being damaged by lower demand for cars and this has a compounded effect both on the value of the Euro and on the value of key European markets, specifically the DAX.

United Kingdom, but the problems are the same

Why interest rates will stay on hold for at least 9 months |  UK markets started to rise as soon as the opinion poll gap between the “yes” and the “no” votes in the Scottish referendum widened. This was as much out of a sense of relief as anything else. A more considered, if slightly glib, response when the final votes were counted came from a BBC interview with a bond trader, his view was that it would be business as usual: markets would start looking back at “fundamentals” and price in a rise in interest rates early next year.

Delta Economics does not see a rise in interest rates as likely in the next 9 months. This is because the macro-economic fundamentals, specifically trade, are too weak for this to be an option for the foreseeable future. The reassurance that the United Kingdom will remain intact as a currency union may initially play well with market sentiment; however, over a longer time period of time the spectre of falling prices and the performance of real economy in the form of exports cannot be excluded from the Bank of England’s thinking on interest rates. Add to this three things: first, there will be a Westminster election in May 2015; second, between now and then Scotland’s membership of the UK is to be renegotiated; third, if there is a Conservative government after May 2015 then there will be a Referendum on EU membership in 2017. All of this creates enough uncertainty around investment decisions to render an increase in UK interest rates extremely inadvisable.

But leaving the politics on one side, the first reason for suggesting that the UK cannot raise interest rates is that there is evidence of disinflation in recent historical export trade figures. Nominal values of trade have been on a downward trend since October 2011 and the UK’s annual export growth in 2013 was just 0.3%. In current prices, Delta Economics is forecasting negative export growth in 2014 (-0.65%) and 2015 (-0.1%) as illustrated in Figure 1.

 

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Figure 1  |  Value of UK exports, June 2001-August 2015, USDbn versus Euro per GBP, June 2001-August 2014
Source  |  DeltaMetrics 2014, Bloomberg

As Figure 1 also shows, there is a low correlation between trade and the value of sterling against both the dollar and the Euro. This indicates that there are no advantages to be gained from altering interest rates. Higher rates would not be a powerful tool to make imports cheaper and, as there are disinflationary pressures anyway, lower import prices may be something that policy makers should avoid. Similarly, higher interest rates may push up the value of sterling but could damage exports and will exacerbate deflation.

In any case, sterling’s value has risen against the Euro and the dollar over the last 18 months and it would be dangerous to accelerate the process too quickly. Illustrated in Figure 2 are the UK terms of trade (i.e. the value of exports in relation to the value of imports), which have been improving gradually since early 2013 when sterling first started to strengthen. A gradual process allows UK exporters to become more competitive through quality and productivity rather than focusing simply on price. A hike in interest rates would distort this and make exports artificially expensive thereby lessening the impact of any productivity improvements by widening the gap again.

 

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Figure 2  |  UK terms of trade vs Euro per GBP, last price monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

Second, the sustained uncertainty around the global economy, European and Asian demand is affecting global trade. As Trade Views have noted successively, actual trade in 2014 is substantially below IMF expectations but, with the IMF and the OECD now reducing their forecasts for growth in 2014 and suggesting that Q4 may see a slowdown, it is likely that the manufacturing and export Purchasing Managers Indices (PMI) will suffer over the next 6 months. Our Trade Corridor Index – Sentiment (TCI-S) for the UK certainly suggests that the key PMI sentiment indicator is currently disproportionately high compared to export performance.

The correlation between changes in the Delta TCI-S and the PMI is over 70% and the flat outlook for UK trade is reflected in the TCI forecast; it is likely that the PMI will drop over the next few months reflecting the inherent weakness in underlying trade conditions and reducing the likelihood of a rate rise.

 

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Figure 3  |  Delta TCI-S changes against changes in the PMI, June 2001-December 2016 (forecast)
Source  |  Delta Economics analysis

Third, the trade of key innovative exports sectors like cars and pharmaceutical products is highly correlated with the last price monthly value of sterling against the Euro (70% and 79% respectively). Both have been falling over the last few months as sterling has strengthened. Substantial policy effort has been put behind stimulating export growth in both of these sectors and particularly to China. Given that both are forecast to grow substantially over the next two years it is unlikely that the Bank of England will raise interest rates. This is because the effect of a rise in interest rates would be to strengthen sterling too far, too fast. This could potentially jeopardise any embryonic export-led growth outside of Europe.

 

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 Figure 4  |  Value of UK exports of private cars to China (USDbn) vs Euro-GBP Last Price monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

 

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Figure 5  |  Value of UK exports of medicines to China
Source  |  DeltaMetrics 2014

Fourth, trade is currently a drag on GDP. This is illustrated by the UK’s net trade openness: in other words the UK’s net exports as a proportion of GDP. The fact that this is falling means that the increases in GDP are forcing a rise in the deficit. This is creating the biggest drag on GDP since the financial crisis.

 

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Figure 6  |  UK net exports as a proportion of GDP vs Euro per GBP, Last Price Monthly, June 2001-August 2014
Source  |  DeltaMetrics 2014

The disconnect between rising GDP and net exports has, as a consequence, created an asset bubble. The correlation between FTSE 100 and economic fundamentals trade has weakened since October 2011; the FTSE has risen while nominal trade values have been on a downward trend suggesting markets are no longer pricing in macro fundamentals such as trade. Disinflation, as evidenced by nominal export values and falling volumes (the forecast in current prices) means that this over-valuation is unsustainable. However, without a gradual correction, a rise in interest rates would exacerbate this detachment and pose the risk of a greater correction in Q4.

 

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Figure 7  |  Value of UK exports (USDbn) vs FTSE 100 Last Price Monthly, June 2001- August 2015
Source  |  DeltaMetrics 2014

There are manifest reasons why a rise in interest rates is inadvisable in the current situation. In essence they boil down to the fact that national and global geo-political and economic uncertainties are too great to make a rise in interest rates probable in the next 9 months. A cynic might say that, in any case, there is a UK general election in 2015 and interest rates will not rise before then, but the weight of economic evidence suggests that there is no forecast pick up in the real economy or improvement in productivity. The economic problems remain the same and the process of building competitiveness through high value exports would be damaged by any increase in the value of sterling as a result of a rise in rates.

 

Born in the USA

Why America’s trade policy matters  |  Last week it was announced that US GDP failed to grow at the rate in Q1 analysts were expecting. To add insult to injury, Gazprom decided it was going to conduct its trade with China in Yuan or Roubles rather than US Dollars. The market reaction was decidedly muted. Does this mean that traders are just so buoyed by sentiment that they are no longer betting on macro indicators at all? Or has the rise of the Yuan already been priced in?

Neither answer seems particularly satisfactory. The clue may rest in the reason why the annualised drop of 2.9% in GDP was so large. The cold winter and health care costs were a significant part of it, but, more importantly, some two-thirds of the drop was accounted for by weaker-than-expected trade performance. Trade, as we might conclude from Obama’s erratic attention to key trade agreements such as TPP with Asia and TTIP with Europe, is apparently less important to the US economy than assets prices, such as housing. A temporary drop in trade won’t do as much damage as a drop in sentiment that might stop people buying things; the US is not returning to recession. So, that’s alright then.

This is an ill-advised, if not downright illogical thought process. Make no mistake about it, trade matters to the US economy. Exports will be worth USD 1.6tn to the US economy in 2014 and imports some USD 2.3tn. Compared to 2001, the US’s trade openness (exports + imports as a percentage of GDP) has grown from 16% to nearly 28%. Delta Economics is forecasting that by 2020, trade will be 36% of GDP on current trends. More than this, as Figure 1 illustrates, trade is also highly correlated with the value of the S&P 500.

 

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Figure 1  |  Value of US trade (USDm) versus S&P 500, Last Price Monthly, June 2001-May 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

So while traders themselves may not react to macroeconomic or trade-related news, the correlation of above 70% suggests that there are reasons why they should watch trade more closely. And in fact, the correlation with imports is slightly higher, at 71%, not least because of the size of the trade deficit that the US runs.

Much of that trade deficit is with China in particular and Asia-Pacific in general. In fact, the trade with the key global regions where US trade policy has currently stalled constitute 56% of US trade and Asia-Pacific is the most important of these in value terms.

 

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Figure 2  |  Value of US trade (USDm) with key trading regions: the EU28, ASEAN and Asia-Pacific

Source  |  DeltaMetrics 2014

 

Figure 2 shows clearly is that although trade with Asia-Pacific has grown by 4.5% in the last 12 months, the trajectory for the rest of the year is relatively flat for all regions. Much of this growth was in Q2 2013 for all three regions and year on year 2013-14 growth is likely to be much lower at under 2% for Europe and just above 3% for ASEAN and Asia-Pacific.

Admittedly US exports are growing relatively quickly at above 3% while imports are forecast to fall in 2014 by nearly 1%. But as the S&P 500 is more correlated with imports than it is with exports, this should give policy makers pause for thought: might it be that markets are perhaps more interested in the activities of US-based global supply chains in Asia that import into the US, than they are in the re-shoring of US jobs evidenced through higher levels of export activity?

 

2014-06-30_bornInTheUSA_fig03Figure 3  |  Why US Policy needs to think about Asia

Source  |  DeltaMetrics 2014

 

Figure 3 shows that the US terms of trade (the price of export in terms of the price of imports) are not especially correlated with the value of the Dollar against the Euro but are with the value of the Dollar against the Yen. More than this, although trade with Europe is strongly correlated with the value of the Dollar against the Euro, this may well be because the Euro is a trade currency rather than a speculative currency. What is quite apparent from Figure 3 is that the correlations across the board: with the S&P 500 acting as a proxy for US assets and sentiment more generally, and with the USD versus the Yen are significant with both Europe and Asia, but strongest of all with Asia, reinforcing the view that the TPP and the TTIP talks are vital to US trade, if not directly to US GDP.

Yet China will be excluded from TPP talks. As the US’s third largest export partner and largest import partner this seems odd, and with a trade deficit that the US runs with China is forecast to be some USD 370bn a reminder that actually the US cannot afford to be overly protectionist in its relations with China. The US terms of trade with China are 84% correlated with the S&P 500 underlining the importance of the fact that US companies have strong interests in supply chains that run into and out of China across the Asia-Pacific region.

 

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Figure 4  |  US terms of trade with China vs Yen per USD, June 2001-May 2014

Source  |  DeltaMetrics 2014, Bloomberg

 

Nowhere is the importance of supply-chain dependency more clear than in the trade competitiveness of US electronics. In 2001, the US had a Normalised Revealed Comparative Advantage (NRCA) in exports of Computers of 0.11 and in semi-conductors of 0.14. By 2006 in the case of computers and 2010 in the case of semi-conductors this comparative advantage had turned into disadvantage of -0.01 and -0.1 respectively. By 2014 the equivalent figures were -0.2 for both sectors. In fact, it is only the US’s increasing self-sufficiency in oil and natural gas that is improving the outlook for US exports with a near 50% improvement in the Revealed Comparative Advantage of mineral fuel exports by 2020. Even if the NRCA figure is still forecast to be mildly negative, this is a vast shift on its 2001 value of -0.62.

The wonder is why anyone should be surprised. From the mid-1990s onwards the globalisation strategy of large US multinationals was to outsource to China (and now the rest of Asia), the automated processes within semi-conductor and computer manufacture that could be done more cheaply but equally as effectively there. That process, now so established across more sectors, is hard to turn around once it has started and explains, to a large extent why US markets are so correlated with both imports and trade with Asia.

The problem was, as the song goes, Born in the USA. Maybe markets should be looking to Springsteen’s lyrics to predict what happens next:

“….Come back home to the refinery,
Hiring man says, “Son if was up to me….”

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.

 

Click to view larger version

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.

World

Delta Economics is forecasting that world merchandise trade will grow by just over 1% in 2014. This is lower than its previous forecast, released in December 2013 of 1.7% and substantially lower than the World Trade Organisation’s forecast of 4.5% world trade growth for 2014. While at a country level, there are some positive growth stories, trade in 2014 is likely to be lower than trade in 2013 and this is dampening our global growth forecast.

The lower global forecast also reflects several things:

  • The effects of geo-political crises (specifically Russia’s annexation of the Ukraine which has created market uncertainty and raised the threat of sanctions, higher oil prices and slower economic growth because of constrained investment.
  • The effects of deflationary pressures in Europe and Asia which have already evident in the nominal values of trade for 2012 and 2013.
  • Lower actual trade growth in 2013 than was anticipated.
  • Forecast South-South trade growth of 5% during 2014

Trade and the Ides of March

Why the tide might not be rising | The International Monetary Fund (IMF) published its World Economic Outlook last week under the title, “Is the Tide Rising?”  For anyone struggling with floods in the UK at the moment, this title is either a bad joke or a timely reminder of the fact that economic forecasting, it is said, is designed to make weather forecasters look good.

The IMF expects World GDP growth to be higher, at 3.7% during 2014 rising to 3.9% in 2014 and while it points out the downside risks to the recovery, especially in emerging markets, there is a distinct air of optimism about the forecast.

Yet world trade, and the World Trade Organisation’s (WTO’s) outlook for world trade, remains flat with no return to the multiples of GDP that were seen prior to 2011.  The last forecast that the WTO published for 2013 was that world trade would grow and their own Head, Roberto Azevêdo was last month expecting the actual numbers to come in lower than that calling its relatively optimistic forecast for growth in 2014, of 4.5%, into question immediately.

The WTO is being characteristically positive at the start of the year as illustrated in Figure 1 which shows the forecast against actual trade.  The figure for December 2013 is provisional and will not be confirmed until April 2013.  The annual peaks in the forecast are in the first quarter of each year – Spring Tides, maybe.

2014-02-04_idesOfMarch_fig01_v03

Figure 1 | WTO forecast for World trade growth vs Actual growth: October 2011-January 2014

Source | DeltaMetrics 2014

The reason for the peaks in the forecast in the first quarter of each year are evident from a closer scrutiny of world trade data on a monthly basis, as illustrated in Figure 2.

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Figure 2 | World trade growth: 2001-December 2014, actual and yeay-on-year

Source | DeltaMetrics 2014

NOTE: Data is actual IMF data up to September 2013, is Delta Economics estimates to January 2014 and thereafter forecast

Figure 2 unsurprisingly shows the big year-on-year drop in trade in 2009, but it is the time after that, especially since October 2010 that helps us explain why the IMF and WTO are optimistic at the start of every year.  There are cyclical upticks in trade in each year in Q3 and Q1 which, when examined as part of a “Net export” effect in GDP forecasts, have a multiplier effect.  However, what is clear from the analysis of year-on-year changes in Figure 2, is that the momentum has been downwards (both actual and estimated) since mid 2011 and that the pattern of post-crisis trade is actually substantially different to pre-crisis trade.

The other reason why the WTO and IMF may be over-optimistic in their start-of-year forecasting is because of the seasonal volatility in China’s trade data presented in Figure 3. Each year, a major drop in Chinese trade, visible throughout the period between December and January is upwardly adjusted by March leaving the trend trajectory one of growth.  These swings have been particularly obvious since the financial crisis and although there are similar seasonal patterns in Germany, the US and the UK but the swings are less marked.

2014-02-04_idesOfMarch_fig03

Figure 3 | Selected Countries’ Export Growth, June 2001-December 2014

Source | DeltaMetrics 2014

Based on the IMF’s own data up as far as the end of September 2013 as these charts are, it is easy to see why Roberto Azevêdo might be cautious about trade growth in 2013.  However, historical growth is of interest only to economists attempting to establish the scale of the damage that is currently being done by the slow-down in world trade.

What is more worrying is that the lessons from past trends seem to be buried in the past as well and that more recent analysis of what is happening with trade is focused simply on a dogmatic assumption that world trade growth has to return to a multiple of GDP growth (often taken to be 2.5 times GDP growth) if the world economy as a whole is to reach an “escape velocity” growth.

Trade since the crisis exhibits different patterns, more volatility and much slower year-on-year growth than pre-crisis.  Evidence from sectoral analysis of trade suggests that this is because global supply chains are using local content to service local markets and that global regional analysis yields more insight into how this fuels trade within regions rather than between regions.  While trade between emerging economies, which is highly commodity focused, remains flat because of the current economic challenges they face, the effects of export-led growth will be limited.

The temptation is nevertheless to watch trade growth and assume that, if it picks up, it will lead automatically to an increase in GDP.  We can expect a market rally during March when, if past trends are replicated, the tide really does rise and Chinese trade data for Q1 is corrected.  While the Delta Economics’ forecast suggests only modest trade growth in 2014 at around 1.6%, and while this is substantially below the current WTO forecast, as Brutus said, “There is a tide in the affairs of men, which, taken at the flood, leads on to fortune.”  This may only be short-lived, and all forecasters (whether economic or weather) should beware the Ides of March.