Slowdown in world trade savages EM FX
Weak global trade and increasing import substitution have signalled bad news for emerging-market FX in 2014, particularly in those countries that rely on a vibrant export sector to drive their economies. 2015 should provide some respite for manufacturers, but commodity exporters will remain in the line of fire.
Emerging market (EM) export volume growth in 2014 received a beating thanks to the fall in commodity prices, sluggish eurozone growth, and a weaker relationship between US expansion and global export volumes.
Falling export volumes matter for FX. The prices per unit of goods traded has been falling in 2014, even where volumes have held up or increased, meaning the value of exports in dollar terms has often declined.
“Trade is critical in determining currency levels in a free-floating regime as they look for a level that makes prices for exports competitive again to revive trade,” says Luis Costa, head of CEEMEA strategy at Citi.
The export slowdown has been bad news for EMs that rely on exports as a main source of GDP – and by extension, their currencies.
“South Africa, Indonesia and Brazil are among the economies to be hit hard by shrinking demand for their exports and this trend will continue in 2015,” says Costa.
The increasing interconnectedness of global value chains and China’s status as the world’s manufacturing hub has rapidly shifted the dynamics of global trade for the past two decades.
However, what has remained consistent has been the structural importance of G7 import demand and EM export volume growth. Nevertheless, as the Bank of America Merrill Lynch (BAML) chart lays bare, the drop in EM exports has been particularly weak this year.
This weakness has triggered two fears: the declining importance of developed market (DM) growth for EM trade, and the risk China’s weaker growth could savage EM exports. On the latter risk, BAML analysts calculate that a 50 basis point drop in Chinese nominal growth could lower EM export growth by 10 to 60bp. However, this relationship is not as important as the trajectory for DM growth and import demand.
Mercifully, however, BAML analysts find limited evidence of declining sensitivity of EM export volumes to US growth.
“As Chart 49 suggests, the shock-response estimates are affected by the large pullback during the crisis,” state BAML analysts. “The reaction to US growth shocks jumps when the dataset is extended to 2010, but moderates when the full sample to 2014 is used. All said, however, EM export volumes still look likely to rise by about 4pp one year after a 1pp increase in US GDP growth.”
In fact, BAML analysts are relatively bullish, arguing manufacturers should stage a recovery next year.
Others argue it is unclear whether the relationship between US growth and EM exports has substantially weakened.
Manik Narain, EM strategist at UBS, adds: “The US is growing, but its propensity to import has declined. Each 1% growth in US domestic demand is generating less imports than it used to. This is true for non-oil imports too. It is a different texture of recovery to what we have seen and that is partly because of the sectors that are leading US growth today.
“The most vibrant sectors have been areas like heavy machinery and transport, and these are areas where the developed world has a competitive advantage.”
EMs have generally specialized in exporting things such as consumer electronics, but demand here has not picked up enough to boost their exports. This is partly due to the specifics of the US recovery.
Take its housing boom. In the past, rising house prices have made consumers feel wealthy and boosted spending on products EMs make, but the US housing recovery has mostly come from buy-to-let investors, meaning US consumers are not feeling much richer.
What is clearer is the relationship between commodities and EM FX.
Of the fragile five – Indonesia, South Africa, Brazil, Turkey and India – the best placed look to be Turkey and India, the big oil importers who will get a boost from cheaper prices. As an oil exporter, Indonesia is exposed to falling prices. South Africa also gains from cheaper oil imports, but is hurt in equal measure by the falling price of its resource exports, while Brazil is also exposed to falling commodity prices.
Terms of trade have moved against some EMs in particular as the prices of different goods have changed.
“The obvious beneficiaries of the recent moves have been classic energy-importing economies like INR, CE FX, KRW and TRY,” says Citi. “RUB and COP find themselves on the other side of the spectrum.”
However, fewer EMs have adopted a mercantilist approach with respect to its FX policy, despite talk of G7 currency wars.
Citi’s Costa adds: “Draghi can’t say it openly but he has hinted strongly – after the first cut of the year, he said ‘look at where your dollar is’ as evidence his policy was working. He has to be careful with the tone of the rhetoric, he can’t say explicitly Europe is embarking on competitive devaluation, but that is what it is.
“Devaluation has not been as efficient at boosting exports as it was in the 90s. After the Asia crisis it was very efficient for countries like South Korea, Taiwan and Indonesia. But this year we have seen the South African rand go from 9.75 to 11.30 against the dollar, with a minimal impact on the current account deficit. This is partly because there are structural issues at play too, but mainly it’s because there is less demand for its exports. So investors have had to change the way they read EM export data.”
The big question is what lessons EMs will heed from the volatility in trade volumes in 2014.
Narain at UBS says: “Post crisis, as EM exports have stayed weak, policymakers have relied on cheap domestic credit to stimulate growth. But this growth model is exhibiting diminishing returns to scale: they need a Plan B. Declining productivity and rigid wages are checking their competitive advantage.”
There are a number of alternatives available. Danny Tenengauzer, head of EM and global FX strategy at RBC Capital Markets, says: “EMs will be looking at alternatives to currency devaluation to boost competitiveness. Structural reforms are one route, but most look more inclined to increase capital spending on infrastructure like roads, railways and education, which should increase productivity.”
Narain adds: “After the last crises in LatAm and Asia, EMs responded with waves of structural reforms. It isn’t clear the same appetite exists in these countries now. India has led the way thus far and it’s possible that new parts of the Brazilian and Indonesian administrations will rise to the challenge. But overall you need to look under a microscope to see the progress that is being made.”
Narain concludes that the bull market that triggered an expansion of global export volumes over the past decade is now in doubt, adding: “The period 2002-2007 was characterized by a series of exceptional circumstances. There was the euro-area enlargement, there was the lift to global trade and growth from China’s admission into the World Trade Organization (WTO), and its investment-centric stage of development. Import tariffs fell globally. And, icing on the cake, US real rates were also declining.
“All these factors fed the boom, but they have worn off. Global trade can’t maintain the intensity of the early noughties, a more realistic comparison may be the 80s.”
RBC’s Tenengauzer agrees, adding: “The global trade expansion in the 90s and noughties was driven by two big events in particular: the establishment of North America Free Trade Agreement, which created an economic area bigger than the EU, and China’s entry into the WTO.
“It isn’t that trade is declining, it has plateaued. To grow again at the rate it was we would need some kind of free trade deal of a similar scale to those.”
However, while other economies lack China’s clout in driving aggregate EM trade volumes, there is also the hope other economies will make great leaps forward in their development to help boost global trade, which could see strong performance from those currencies.
Some political stability could transform the economy of a country such as Egypt, sitting on Europe’s doorstep with a cheap labour force, which could offer a competitive advantage to further-flung countries such as Vietnam for manufacturing. That could be transformational for the Egyptian pound.
Tenengauzer concludes: “My big hopes are India and Indonesia, which have huge populations; India’s being largely English speaking. Both look increasingly eager to integrate more with the world economy. That could make a real difference to global trade.”