Why Global Trade Is Struggling

A lot of people for a long time have been predicting it, and a lot of people are eager for it to come, or at least think they are. As the data continues to worsen, it’s only a matter of time till the mainstream media picks up on the story.

The day has come!  It’s the end of globalization!

By the most common definition of recession, global merchandise trade is already in one. Volumes of internationally traded goods shrank by 0.5% in the second quarter, after shrinking 1.5% in the first, according to the Dutch government’s World Trade Monitor. Those are equivalent to 2.1% and 5.9% annualized paces.

This hardly compares to the fall and winter of 2008-2009, when global trade in goods shrank by 7.2% and another 10.9% in two consecutive quarters. Volumes of traded goods were still up by 1.1% in the second quarter of 2015 versus the second quarter of 2014.

Also, these numbers don’t include trade in services. International business process outsourcing is still booming, and international tourism is doing fine.

Still, there’s no doubt global trade is struggling. Judging from the recent drops in commodities prices, nobody is expecting trade growth to bounce back anytime soon, not even to the 2.6% pace it averaged in 2012 to 2014. A return to the long-run average of 7% annual global trade growth that prevailed until 2007 seems more far-fetched than ever.

Emerging Markets In Crisis

This is far from the end of globalization. But it is a crisis, and one that could last a while.

The problem is in emerging markets, which had been leading global trade growth since the 2008-2009 crisis. Imports by low and middle-income countries accounted for 71% of the growth of global merchandise trade between 2008 and 2013, though even by the end of that period their imports were only 31% of global merchandise trade. Those figures are by dollar value and are calculated from World Bank data.
 
Trade among emerging markets was especially strong. Imports by low and middle-income countries from other low and middle-income countries accounted for a third of global merchandise trade growth from 2008 to 2013, even though by the end of that period they still accounted for only a tenth of global merchandise trade.

When countries punch so far over their weight, they tend to tire quickly. Put another way, the catch-up process for emerging markets is inevitably cyclical.

Above all, trade growth in 2008-2013 was driven by a frenetic pace of building in China. Housing, retail space, offices, industrial plants and infrastructure were all built as quickly as possible, financed from foreign investment and booming exports. That drove up prices of imported raw materials, especially oil and ores, but China was able to keep up by continually boosting its exports, especially to its raw materials suppliers.

That growth model has been unraveling since 2014. One reason was that Chinese households became reluctant to invest further in housing. I don’t have good data, but based on anecdotal reports, it appears that a large portion of middle- and upper-class Chinese families already hold apartments for investment, and a large portion of those are empty. As apartment prices in most cities have stopped rising, owners of empty apartments are taking losses as their apartments age and depreciate, which is a powerful warning to potential buyers.

Another reason global trade is struggling is the fracking boom in the United States, which by driving down the price of oil hit the incomes of the raw-materials producers that had been most rapidly increasing their imports from China. Steel and iron ore prices crashed as construction industries contracted in Russia, the Middle East and other raw materials exporters, adding to the slow-down of construction growth in China.

Emerging market currencies devalued, even those of materials-importing manufacturers. The dollar value of emerging markets imports didn’t grow at all in 2014, and both values and volumes have been dropping this year.

The next chart is of merchandise trade volumes, again from the World Trade Monitor. It shows how emerging markets, the red line, led global trade growth for many years, and how sharply their demand for imports has recently collapsed.

A Developed-Economy Recovery Isn’t Enough

 

Meanwhile, the United States has reverted to its former status as the biggest driver of global trade demand, at least this year. Import volumes were up 7.4% year-on-year in the first half, according to the Dutch data. A much-touted “re-shoring” trend has been overwhelmed: US manufacturing employment has been flat this year after a modest partial recovery in 2010-2014.

But the US demand growth looks like a one-off that stems directly from the fracking boom. As oil prices and oil import volumes have dropped, the dollar has appreciated, and Americans have reallocated much of their extra wealth to more imports. Latin America has been the biggest beneficiary, with its export volumes up 9.6% year-on-year in the first half of 2015.

But oil prices can’t fall much further. And as you’ve surely noticed, many consumer goods markets in the US are already saturated with imports. By my best estimate, close to half the value of manufactured or processed goods consumed in the US is imported. According to the BEA’s input-output tables, $4.4 trillion worth of manufactured or processed goods were consumed in the US in 2013 by non-manufacturers, not including logistics and trade mark-ups. That year $2.3 trillion worth of goods were imported, of which some obscure but small fraction was re-exported.

Europe has been more or less pulling its weight in global trade since last year. The Euro Area has increased its merchandise imports at an average pace of just over 2.5% a year since the beginning of 2014. But that pace is also unlikely to accelerate. With its numerous highly integrated economies, Europe’s goods markets are already very saturated with imports. International trade within the European Union accounts for about a fifth of global international trade.

Like the name of my blog says, the world economy is already globalized. I believe there’s still much more to come, especially in global trade of services. And of course, any globalized supply chain has at least as much natural potential for growth from improvements in quality and efficiency as any domestic supply chain. But global trade growth will no longer be driven by developed economies substituting imported goods for domestic products.

Trade among emerging markets is now the biggest potential driver of global trade growth. But that growth will be cyclical, and right now we are in a weak stage of that cycle.

Only when emerging markets are growing rapidly can the pace of global trade growth exceed the pace of global GDP growth. When emerging markets are in crisis, global trade will stagnate, even if developed economies are strong.

A Few China Charts To Ponder

Writing about the Chinese economy can be daunting, not only because it’s so big. China is just plain extraordinary. Things in China work differently from elsewhere, sometimes astonishingly so. Predicting how such an unusual place will change is close to impossible.

But change is certainly in the air. The news of the moment is capital flight, which is believed to be accelerating. Not long ago China was a very difficult place from which to export capital. Lately all sorts of formal and informal holes have been opening up in the old system of capital controls. Chinese money brokers boast they can turn your yuan in China into dollars in a foreign bank account in about an hour.

Nomura’s chief China economist, Yang Zhao, estimates that $100b was sent or pulled out of China in the first three weeks of August, on top of $90b in July. That’s according to the Daily Telegraph’s summary of his private research. Much if not most of the departing money represents Chinese investors paying off dollar financing and liquidating long positions in the yuan or commodities.

The trigger for this exodus was a mere 3% drop in the value of the yuan, a scale of devaluation that anywhere else would have been taken in stride. But the Chinese currency market is so carefully managed that a 3% move wasn’t just shocking. It was understood to represent the tip of an iceberg of market pressure.

And indeed the yuan has been under growing pressure for about a year. The central bank’s decision to hold the yuan stable against the strengthening dollar resulted in a costly appreciation against most of China’s trade partners. With export growth slowing, that has been difficult to defend. As of the end of June, the central bank’s foreign exchange reserves had shrunk by about $340b over the past 12 months. Probably about half of that was devaluation of non-dollar assets, and the rest was spent intervening in currency markets to prop up the yuan.

Now the central bank is believed to be spending FX reserves much more rapidly, as it struggles to prevent further depreciation. The pace and scale of its intervention is likely more than $10b a week.

That’s the background in which I present the next three charts. I don’t mean them to provoke alarm or to spread a sense of doom. Remember, China is different.

One way China is especially different is its very large volume of bank deposits. As of the end of June, China’s M2 money supply, which includes circulating currency and bank deposits, came to $21.5 trillion. M2 is defined somewhat differently in different places, so international comparisons aren’t exact. But if taken at face value, China has about 75% more M2 than the United States, although the US economy is still about two-thirds bigger than China’s.

What this chart shows is a sizable portion of the world’s wealth moving into Chinese bank deposits. That has happened partly thanks to the considerable wealth-generating power of China’s export-oriented industry, and partly because in China other kinds of financial assets are less developed. Bank deposits in China substitute for any kinds of public and private savings, insurance and safety nets one finds in advanced economies.

Those $21.5 trillion worth of Chinese deposits and currency also represent the opposite side to commercial bank and central bank assets. The largest and most important part of those are commercial bank loans, which in China are largely state controlled and often used as a kind of quasi-fiscal stimulus. China had $15.2 trillion worth of bank loans outstanding at the end of June, compared to $12.9 trillion at Euro Area banks and just $8.3 trillion of bank loans in the US, where bonds are favored over loans in corporate finance.

In other words, the value of deposits in Chinese banks is backed mainly by the loans those banks made to finance China’s urbanization and industrialization.

The next chart puts the difference between China and major advanced economies in starker terms. Instead of comparing the outstanding stocks of M2 across economies, this chart compares the flows of new M2 being created, relative to GDP.

And here you can clearly see how different China is.

Remember all the talk about the vast sizes of advanced-economy quantitative easing programs? You might be able to see those here, barely. Major advanced economies have been adding M2 at paces that usually hover around 5% or less of GDP, broken mainly by a surge of M2 creation in the Euro Area before the 2008-2009 crisis. But even that didn’t come close to the pace of 15%-40% of GDP at which China has been adding M2. Remember, most of that M2 creation in China is through commercial bank lending.

The good news is: the loans tied to this M2 growth have by and large worked, despite some that haven’t. Chinese exports grew from about $320 billion in 1999 to $2.2 trillion in 2014. That’s according to the import data of China’s trade partners, so there’s no question of fudging. Even after accounting for dollar inflation, that still represents an almost quintupling of exports over 15 years, or an average growth pace of about 11% a year. That couldn’t have happened if loans were rampantly misspent.

The other good news is that Chinese people and companies seem to mostly trust that their deposits will be made good. One of the main distinguishing features of an undeveloped country is lack of popular trust in bank deposits. The least developed countries of the world typically have M2 to GDP ratios of less than 25%, and if they attempt to grow M2 too rapidly, most of it turns quickly into circulating banknotes and drives inflation.

The Chinese people’s willingness to hold bank deposits is evident in the fact that M2 reached 204% of GDP at the end of June. That compares to 184% in Japan, 98% in the Euro Area, and 68% in the United States. When people are willing to hold increasing volumes of bank deposits as savings, that sterilizes liquidity and allows banks to boost lending without driving a lot of inflation.

The bad news is: the supply of bank deposits in China is nonetheless probably too high. There appears to be a large pent-up demand in China for alternative financial assets in which to save. The high-flying, short-lived equity bubble of last November to June can be seen as one symptom of that pent-up demand. The same can be said of the over-investment in residential apartments that prevailed until last year, leaving a glut of unoccupied flats held for investment.

The current wave of capital flight could be another symptom of pent-up dissatisfaction with deposits. After all, even one-year time deposits earn only about 1%-1.5% in real terms. A 3% devaluation and a perceived threat of more are serious reasons to reconsider trying to save that way. However unusual China is, it can’t get around that it’s still a developing country without the rule of law and other liberal traditions that underlie popular trust in bank deposits in advanced economies.

The other bad news is: China’s bullish lend-and-grow strategy might not be working anymore. Many people have tried to call its expiry date before and been proved wrong, so I wouldn’t be too certain. But it does appear that large sectors of China’s industry are hitting a wall of overcapacity.

That’s most clearly reflected in the fact that nominal GDP growth, especially in US dollar terms, has slowed much more rapidly than real GDP growth. Nominal GDP growth in the first half of 2015 was just 6.5%, less than real GDP growth. That means output volume gains are driving down prices.

One of the biggest problems for China is that most of its fastest-growing export markets were its suppliers of raw materials. They have been hard hit by big drops in prices for those materials, and many are devaluing their currencies and sharply reducing imports.