Currency Values Hardly Impacts Merchandise Trade

In the eyes of the mainstream the only way to generate export growth is to devalue a currency or impose punitive tariffs on trade partners whom are deemed as 'currency manipulators'.

Yet, facts belie these misguided conventional beliefs.

Referring to the above charts, analyst Howard Simons argues, (bold highlights mine)

``First, three-quarters of the import weights and two-thirds of the export weights derive from five sources: China, Canada, Mexico, Japan, and the eurozone; the others will be aggregated for visual clarity. Let’s take a look at the imports first.

``The most prominent development over time has been the seizing of market share by China from Japan and Canada. Mexico’s share expanded after the passage of NAFTA, but it has stagnated in recent years as maquiladora plants have become uncompetitive with Asian exports. In economic terms, Mexico now is exporting labor, a factor in production, as it has lost a competitive advantage in the production itself.

``On the export side, China is displacing Japan as a customer of the US. Exports to both Mexico and Canada expanded after the passage of NAFTA, as have exports to “all-others;” this category includes important growing customers such as Brazil, India, the Middle East, and the Asian periphery.

``What is or should be striking in the pictures above are the rather constant weights for the eurozone. Given the euro’s prominence for financial flows and for traders, and given its outsized 57.6% weight in the dollar index, you might think all of the changes over the years in the rates between the dollar, the euro, and its predecessors would lead to substantial changes in trade weights.

``The US and the eurozone have structurally similar economies and factors of production. As a result, we trade in similar goods where differences in customer tastes and small quality differentials mean more than price. Moreover, much of the trade between the two zones is inter-subsidiary and represents a transfer."

True enough, (chart courtesy of netdania) despite the Euro's 5 year uptrend, this has hardly affected the trade weightings of the Eurozone vis-a-vis the US.

In addition, many other factors also seem to impact trade more than currency values, such as Free Trade Agreements, differentiation of goods, transfer pricing from inter-subsidiaries, and etc...

In other words, currency values hardly is the major factor that influences trade balances.

I'd like to interpose another perspective--how did the Euro become an export giant, in spite of the currency's elevated valuation levels?

Analyst Martin Spring enumerates the strength of Germany as the Eurozone's driver: (all bold emphasis mine)

-Germany is a hugely powerful exporting power, only recently overtaken by China, and still a far bigger exporter than the US or Japan. This year it is forecast to have a foreign trade surplus of $187 billion, not far behind China’s $219 billion.

-Despite some of the highest labour costs in the world, it has high productivity to match them.

-Due to the cohesion that comes from good employer-employee relationships, manufacturing industry has the flexibility to meet adverse circumstances. In the global recession it has kept growth in unemployment to just half a percentage point through measures such as pay cuts and state-subsidized short-time working.

-Instead of looking to currency depreciation to ease its problems, it survived the period of a strong euro by meeting competition head on. The OECD, in its latest economic survey, says the nation used the adversity to spur innovation, make allocation of resources more efficient, and invest strongly in advanced production techniques.

-Its companies have diversified internationally and outsourced to low-cost countries – about half the added value of exports is now produced abroad.

-Although Germany does, like so many countries, have a problem of high and growing public debt, it is at last addressing that problem decisively. Over the 2008-2012 period, despite the biggest stimulus programme in Europe, its debt is forecast to grow by only 17 percentage points, compared to 22 per cent in France, 33 per cent in Greece and the US, 34 per cent in the UK and 39 per cent in Japan.

-The Economist says Germany “no longer suffers from an arthritic labour market, an obese state or a suffocating tax burden.”

-At the core of the engineering sector that is the cornerstone of the nation’s industrial economy are thousands of dynamic Middelstand enterprises (small and midsized firms, often family-owned) that export almost 80 per cent of their production, selling not only highest-quality machines, but also the panoply of expert support services that go with them.

-Germany is a world leader in fields such as automotive technology and renewable energy. It can sell machinery in China at four times the cost of Chinese competitors’.

All these can be summed up into competition, division of labor, competitive advantage and high level of entrepreneurship. In short, Germany's export powerhouse came about from fundamentally embracing free market principles and not from devaluation and closed door isolationist policies.

This bring us to the surprise announcement by China to gradually allow her currency to rise. Will these alleviate the so called global imbalances?

In 2005 the yuan appreciated by 9.8%, yet there has hardly been any improvements in the trade balance (deficit) standing of the US vis-a-vis China, as shown in the above chart.

And the narrowing of the trade gap in 2008 can't be attributed to the rising Yuan, because the world suffered from convulsions of the 2008 financial crisis, which had been a far larger factor.

Besides, China then repegged her yuan to the US dollar at the onset of the crisis (also shown above-chart courtesy of Northern Trust).

So the answer is a NO--the appreciation of the yuan is unlikely to make a significant dent to the US deficits. Moreover, for as long as the US dollar is the de facto medium of account "currency standard" for global trade, the US is likely to maintain huge deficits.

However for China it could be a different story.

China's surpluses could narrow, not because of the appreciating yuan, but because of policies aimed at shifting internal dynamics.

According to Northern Trust's Paul Kasriel,

``Now, I do believe that the rate of increase in China's trade surplus will be slowing in the coming years, but not primarily because of an appreciating renminbi. But rather because rising incomes among Chinese households will lead to increased discretionary spending by them. Also, in order to keep the population relatively happy, Chinese politicians will re-allocate government spending more toward services and infrastructure spending to benefit households rather than export industries."

Bottom line: currency values signify only as one variable out of the many that influence trade activities. Therefore tunneling on the "currency" valve as means to rebalance trade by indirect (inflationism) or direct protectionism is not only fallacious and deceptive but also unwarranted.

Borrowing Howard Simons conclusion, ``the world’s protectionists are better at making noise than making sense".

Proof Of Currency Values Aren't Everything: The Euro

Here is more evidence that "currency values aren't everything".

This from Bloomberg's Chart of the Day, ``The euro’s surge against the U.S. dollar won’t hinder Europe’s recovery from the worst recession in 60 years because revived global trade will blunt the impact of a stronger currency, the Royal Bank of Scotland Plc said.

More from Bloomberg, ``The CHART OF THE DAY shows that euro-area export-related orders rose in October for the seventh time in eight months, according to data compiled by Markit Economics. The gain came even as competitiveness was hurt by the euro’s 17 percent advance in the same period."

“The impact of world trade on euro-area gross domestic product is more than three times larger than that of exchange- rate movements,” said Silvio Peruzzo, an economist at RBS in London. “In the euro area, world demand matters more than the currency.”

Additional comments:

-the purchasing power of a currency is determined by the supply and demand for money. This means that when a currency's domestic purchasing power is on a decline this should be likewise reflected on the relative decline in exchange rate.

-as we discussed in Asia: Policy Induced Decoupling, Currency Values Aren’t Everything, The Evils Of Devaluation, and Bernanke’s Devaluation Is About Debt Deflation, Tenuous Link Between Weak Currency And Strong Exports, it is the markets that matter most.

-Modern markets are complex and are structured in niches. This also means that markets have varying price sensitivity.

Asia: Policy Induced Decoupling, Currency Values Aren’t Everything

``The biggest lesson of the current crisis for Asian countries is that they can no longer depend on the West as a market for their exports, nor for reliable returns on their investment capital. To address the first issue, Asia has to cultivate its domestic consumer markets to sustain its growth. For the second, it faces a potentially more daunting challenge: to grow and strengthen its domestic capital markets, and stimulate Asian investment in Asia. Should Asia achieve these goals, it would mark a fundamental shift in the economic relationship between Asia and the West—and in particular between China and the U.S.” Matthews International Capital Management Asia Now, The Growth Issue

As we have been saying, inflationary policies are essentially vented on currencies which are instantaneously transmitted to the financial asset markets.

Besides, the impact of inflation has always been relative, since money enters the economy at specific points of the economy, and considering the distinct capital structure of national economies, the effects from these policies are likely to be divergent.

Take for instance, high savings, low systemic leverage, and an unimpaired banking system from the recent crisis [as we recently discussed in Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble] are likely to be more responsive to low interest rate policies regime implemented by domestic central banks. The massive outperformance of emerging markets relative to developed economies is a symptom of such response [see Global Stock Market Performance Update: Despite China's Decline, Emerging Markets Dominate]

It doesn’t stop here. This phenomenon has somewhat distilled also into national economies, see figure 5.

Figure 5: Divergent Impact On Industrial Production (Economist) and Car Sales (PIMCO)

Industrial production in the Emerging Asia has sharply been reinvigorated in contrast to the sluggish performance in the US.

The same divergent dynamics can also be seen in the comparative car sales between China and the US.

In short, what you are seeing is a clear manifestation of decoupling at work.

This from the Economist,

(bold highlights mine)

``Across the region, aggressive fiscal and monetary stimulus has helped revive domestic demand. Asia has had the biggest fiscal stimulus of any region of the world. China’s package grabbed the headlines, but South Korea, Singapore, Malaysia, Taiwan and Thailand have all had a government boost this year of at least 4% of GDP. Most Asian countries, with the notable exception of India, entered this downturn with sounder budget finances than their Western counterparts, so they had more room to spend. Bank of America Merrill Lynch forecasts that the region’s public debt will rise to a modest 45% of GDP at the end of 2009, only half of the average in OECD countries.

``Moreover, pump-priming has been more effective in Asia than in America or Europe, because Asian households are not burdened with huge debts, so tax cuts or cash handouts are more likely to be spent than saved. It is also easier in a poorer country to find worthwhile infrastructure projects—from railways to power grids—to spend money on.”

Mainstream analysts, whom mostly have been deflation advocates, jeered and hectored on the decoupling theme following the climax of the US banking seizure last September and October. Unfortunately, it appears that the deflationary episode signified as a fleeting moment of glory and as developments deepen things has once again been turning out to refute their highly flawed assumptions.

Importantly, we described in our February article Fruits From Creative Destruction: An Asian and Emerging Market Decoupling?, that creative destruction, the role of real savings, supply side responses, and the role of Asia’s middleclass could act as possible channels for decoupling.

Currency Values Aren’t Everything

The Economist highlights another point we’ve been making,

``The basic problem is that although the Asian economies have decoupled from America, their monetary policies have not. In a world of mobile capital, an economy cannot both manage its exchange rate and control domestic liquidity. By trying to hold their currencies down against the dollar Asian economies are, in effect, being forced to shadow the Fed’s monetary policy even though their economies are much stronger. Foreign-exchange intervention to hold down their currencies causes domestic liquidity to swell. Consumer-price inflation is not an imminent threat, because prices are falling in most Asian countries. Chinese consumer prices fell by 1.8% in the year to July. But asset prices look dangerously frothy. The obvious solution is to let exchange rates rise, but with exports still well below last year’s level, governments are reluctant to set their currencies free.” (bold emphasis mine)

What we are in agreement is here is that of the US Fed policy transmission to the Asian markets and economy.

Although it would be ideal that Asian currencies be allowed to rise to reflect some of these adjustments, the idea that currencies are the only major factor for adjustments represent as logical fallacies of hasty generalizations based on unfounded assumptions or Ipse Dixitism.

To consider, the Philippines saw its currency the Peso depreciate from Php 2 to a US dollar in 1960s to Php 55 pesos to a US dollar in 2005 (or 96% devaluation!).

Considering the macro assumptions that such magnitude of adjustments ought to reflect on its products, this implies that the Philippines should have been an export giant by now.

Unfortunately this hasn’t been the case. Instead, we became a giant of labor exports, as an aftereffect of a vastly lowered standard of living out of the inflationary policies accrued from present and the previous administrations.

Unfortunately, such simpleminded fallacy of composition by experts deals with the assumption of an economy producing a single good from a single type of labor funded by a single type of capital.

I’ll further the example; San Miguel Beer which cost Php 19 per bottle in a local sari sari store (informal retail outlet), costs Php 50 in local B rated bars, and Php 200 in 5-star hotels. This is known as Price Discrimination, which basically means the selling of identical products to different markets through market segmentation.

In other words, depending on the markets, some products are more price sensitive (price elastic) than the others. In practice, a product that caters to the lower income class of the society is more price sensitive compared to a product marketed to the high end income segment.

So markets, not only prices (through currencies), are the more important qualifying variables for any required economic adjustments.(yet, high profile local experts continue to call for inane Peso depreciation!)

The fundamental reason why the Philippines haven’t benefited from a depreciated currency is because the local political economy has a limited and underdeveloped market due to an unfree economic rent seeking crony capitalist structure which has remained in place until today.

Besides, if currency value is the sole determinant of economic growth then Zimbabwe should be the biggest exporter or the wealthiest nation today!!!

The Japan Experience

More example; if rising currency translates to “greater domestic demand” then why has the Japan’s economy remained an export dependent economy despite the huge (threefold) appreciation of the yen? (see figure 6)

Figure 6:Gold News: Soaring Japanese Yen

Nathan Lewis for the Daily Reckoning says that aside from the deflation in the banking system what mattered most had been the series of tax hikes that has kept Japan’s economy in the doldrums, 20 years from the bubble bust.

This from Mr. Lewis (bold highlights mine) , ``They began with a series of tax measures on January 1, 1990 - the first day of the bear market - which eliminated certain preferential capital gains tax treatments for property. To take a few of a great many such steps which followed: In 1992, the tax rate on short-term capital gains (under 2 years) on property was raised to 90%. Long-term gains were taxed at 60%. A 0.3% National property tax was introduced (this was several multiples greater than existing property taxes). A City Planning Tax of 0.3%. A Registration and License Tax of 5% of the sale value of a property. A Real Estate Acquisition Tax of 4%. An Office Tax of 0.25%. A Land Ownership Tax of 1.4%. Even the regular property tax, the Fixed Assets Tax, was effectively raised by several multiples. From 1990 to 1996, Japanese property values imploded by as much as 70%. However, the revenues from this tax rose by 46%. You can do the math…

``Already there is an annual rise in payroll taxes, scheduled for every year between 2004 and 2017, which will eventually take the payroll tax rate from 13.6% to 18.3%. (Employers match this, and there is no maximum income to which it applies.) And what about the increase in taxes on dividends from 10% to 20%? Or the introduction of a brand-new capital gains tax on equities of 20%, which had effectively been tax-free before? Or the effective 25% increase in personal income taxes, the result of the elimination of a 20% tax cut introduced in 1998? On top of all that, politicians are talking about increasing the consumption tax (similar to a sales tax) from 5% presently to 10% or higher. Until a 3% consumption tax was introduced in 1989, there was no consumption tax at all in Japan, not even at the prefectural or municipal level.”

In addition, John Hempton of Bronte Capital says the legacy of zombie corporations has consumed capital resources which was otherwise meant for other productive investments, ``the problem in Japan was their ability to keep zombie corporations (not zombie banks) alive for decades. Japan has a “Rip-Van-Winkle” industrial legacy to go along with its absolutely brilliant modern technology industries. This old industry sucks resources which would better be used by the modern industry.” (emphasis added)

In short, like the Philippines, domestic policies have been responsible for restricting the required adjustments to expand the marketplace in spite of the currency adjustments. So calling for adjustments of imbalances via the currency route is no less than a fantasy.

Therefore, I’d avoid listening to “expert” economists who would reason along logical fallacies and prescribe snake oil medicines.