Back to reality

Why Dollar-Euro parity is possible  |  Following a turbulent January in Europe, the once unthinkable is now becoming thinkable. Mario Draghi, as was widely trailed, launched €1.1 trillion of Quantitative Easing (QE) to September 2016. And following Syriza’s victory in the Greek election, the prospect of a Grexit is now actively being discussed.

So here’s another “unthinkable”: the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continue. Is this really unthinkable or is it simply a return to the reality that we saw in the early days of the euro?

First, the Delta Economics view is that the euro has been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.




Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. As with the eurozone more generally, it will not be helped by a lower value of the euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.




Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this: the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.




Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015


Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

All of which brings us back to reality with a harsh bump. The likely outcome of all of this is continued market pressure on the euro (Figure 4).




Figure 4  |  Monthly value of eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis


The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year. Whether this will bring the eurozone “back to life” is uncertain, but we are certainly “back to reality”.


Back to reality: why Dollar-Euro parity is possible  |  Trade View Author  |  Rebecca Harding  |  CEO

Webcast 028 | Back to reality

Why Dollar-Euro parity is possible  |  January was a turbulent month in markets and politics. There was really only one story in town: European quantitative easing and the Greek election. What does this mean for trade and markets?



Webcast 028 Author  |  Rebecca Harding  |  CEO

Lost interest?

What do England’s exit from the World Cup and a pending interest rate decision have in common?  |  Since Mark Carney hinted that UK interest rates might rise by the end of 2014 in his Mansion House speech on the 12th June, Sterling has strengthened, reaching a peak against the Dollar last seen in 2009. By the end of the week, Sterling had slipped back slightly and the debate had focused again on how this would affect the enduring problem of UK growth: that without a seismic shift in the productive, and hence export, capacity of the economy, any chance of sustainable recovery remains in the hands of Britain’s consumers. In essence, this is the same as leaving the chances of getting out of the group stages of the World Cup to Italy or Costa Rica. And we all know what happened there.

It is a mistake to think that interest rates changes are going to make much difference to exports at all. For example, the correlation of the USD-GBP spot with exports is only 0.41 while for the GBP-Euro rate it is 0.46. Similarly imports are only 0.38 correlated with the USD-GBP spot and 0.56 correlated with the GBP-Euro spot. In other words, don’t expect interest rates to make much difference to trade at all.

The mystery is why anyone should be surprised at this. Figure 1 shows the two currency spot rates (USD per Pound Sterling and Euro per Pound Sterling) against the one-month Libor rate.



Figure 1  |  The USD-GBP and GBP-Euro spot price, Last Price Monthly, June 2001-May 2014

Source  |  Bloomberg


Over the time period, the volatility in base rates is relatively clear to see, as is the dramatic drop in interest rates to near zero as a reaction to the financial crisis. The substantial reduction in the value of Sterling against the dollar and the Euro between 2007 and 2009 can also be seen. And although there has been a slight improvement in the value of Sterling against both currencies over the past 12 months, this is both independent of interest rates, since these have not changed and, more importantly, in no sense a recovery to the pre-crisis levels. What is interesting about Figure 1, however is the fact that the relationship between interest rates and the value of Sterling against the Euro is much stronger at -0.80 compared to short term interest rates against the value of the US dollar against Sterling, where the correlation is 0.64. In other words, UK interest rates are more likely to provoke a sharper correction of Sterling against the Euro than they are against the dollar.

But whether or not this will impact trade is debatable. Figure 2 shows the historical relationship between short term interest rates and trade over the period since 2001.



Figure 2  |  The Value of UK exports and imports (USDm) versus short term base rates, June 2001-May 2014

Source  |  DeltaMetrics 2014, Bloomberg


Mark Carney is clearly correct to think he can gamble on raising interest rates and it having a minimal effect on trade: the correlation of short-term base rates with exports over the period is -0.18 while for imports it is -0.25. While this is, of course, purely for illustrative purposes, it points to something that economists have suspected for a while of UK trade: that a change in interest rates that leads to a change in the value of the currency will have little or no impact on levels of trade. There has been a near 25% reduction in the value of Sterling since 2008; there has not been a commensurate increase in trade.

Figure 3 illustrates how the Terms of Trade have changed against the value of Sterling against the Euro and against UK base rates.



Figure 3  |  UK Terms of Trade versus GBP per Euro spot, Last Price Monthly, June 2001-May 2014

Source  |  DeltaMetrics 2014, Bloomberg


There is a strong correlation over the period between the strength of the pound against the Euro and the terms of trade of 0.75. In other words, if Sterling strengthens, then the terms of trade over the period will also improve: exports will become more expensive relative to imports. This would almost be a truism were it not for the fact that the equivalent correlation with the Dollar is 0.18 – i.e. there is practically no relationship at all. So why would there be such a difference between the two exchange rates?



Figure 4  |  Why UK trade with Europe is more vulnerable to a change in interest rates

Source  |  DeltaMetrics 2014


First, Europe accounts for 43% of UK goods trade and the US 10%. The UK’s top sectors are medicines, oil (crude and refined), cars and turbo-jet engines and turbines. The US is the biggest destination for both pharmacueticals and turbo jets engines and turbines, and the third and second largest destination for crude and refined oil respectively. Nevertheless, thirteen of the top 3 export destinations for Europe’s top five products are in Europe, helping to explain why the value of Sterling against the Euro is more important than it is against the dollar to UK trade.

Second, the USD-GBP rate is used more for speculation. Across the piece, its correlations with trade are weaker: the Euro is a trade-based currency so Sterling’s value against it is determined by trade rather than by speculation. This may make UK export trade itself more vulnerable should interest rates rise.

Relying on small-scale and incremental interest rate changes is likely to have little impact either on the value of Sterling or on the UK’s trade. The reason for putting up interest rates is usually to quell inflationary tendencies by making the cost of borrowing more expensive. In this case, the goal will be to dampen pressure on house prices which may create unsustainable growth in the UK economy.

But look again at Figure 2 and the trend in exports since September 2011. The values are actual historical values of trade and while the seasonal fluctuations in trade are clear, what is also obvious is a downward pressure on the value of UK exports in US Dollar terms. In other words, we are already seeing disinflationary tendencies affecting the value of UK exports. If interest rates do go up, this puts further negative pressure on inflation, which could create similar downward pressure on UK export prices in spite of a strengthening currency. The danger then would be of deflation brought on by the very instrument that was meant to be a cure: interest rates.

As a recent leader in the Financial Times* pointed out, the issue is one of a large productivity gap between the UK and the rest of the world, particularly the US and Germany. This weakens our manufacturing trade position and, arguably, makes UK exports uncompetitive not in price terms but in terms of the added value embodied in our high-end manufactured goods.

As was pointed out in a previous Trade View, the correlation between skills and UK trade is low at just 0.54 compared to figures of between 0.94 and 0.98 in the US, Germany and India and unless this gap can be closed, our progress towards global high-end competitiveness will be restricted by our productivity base. Like the post World Cup inquest, maybe we should be looking at the drivers of our own weak performance and not at the dominance of foreign players in our markets.


* Leader (June 13th 2014) | ‘Carney’s journey from dove to hawkFinancial Times


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).



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).



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.



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



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.