Globalisation, international trade and the coronavirus.

Last month Tesla finished the first Model 3 cars produced in its new Chinese factory in Shanghai and their production provides useful examples of economic theory in action.

International trade theory suggests that producers making complex products often make them initially close to home, e.g. the Tesla factories in Nevada and New York state, where there are the designers and engineers on hand to deal with production difficulties. Another example is Dyson shifting its manufacturing plant from the UK to Malaysia while maintaining its research and design facilities in the UK. Once the product is refined and the production process is running smoothly, it is possible to outsource production to areas of the world where costs are lower in order to take advantages of those areas’ comparative advantage.

The Tesla factory is the first wholly foreign-owned car plant in China and, from starting construction to producing the first finished cars took less than a year – significantly faster than such a product in the UK. However it is worth noting that the initial negotiations according to Elon Musk, took “years”.

The Chinese-made cars are cheaper than imported models ($50,000 compared to $63,000) and, as production increases and more local components are used, costs will fall further, possibly as much as 20%.

Apart from making it easier to tap the potential in the Chinese market, the ability to produce in China means that the factory’s output would avoid possible tariffs on US exports. In the future, cars might be exported from China to consumers in the UK who would benefit from lower prices.

The above example shows the benefits of international trade and globalisation. However news this week of the effects of the coronavirus shows the reverse situation highlighting the dangers of increased interdependence through global supply chains. Jaguar Land Rover has announced that it could run out of components from China within two weeks. Apple has similarly announced that its iPhone supplies are suffering because of the problems in China where Foxconn workers, the business which assembles phones, have been told to stay away from work because of the virus. In addition, as the Chinese economy has grown, and it now accounts for 16% of world GDP, as well as its role in world supply, its slowdown also impacts on demand elsewhere in the world.

Should economists be worried about the coronavirus?

The coronavirus has been in the news this weekend with the 35,000 people in different countries being affected. In addition, the business pages of many papers are expressing concern about the implications the coronavirus might have on Western economies – what economists refer to as an economic shock – with the Federal Reserve Bank talking of a risk to the global economy. This is because of the increasing importance of China in the world today. Not only is it the second largest economy, accounting for 19.7% of world GDP, it also demands a staggering 69% of world mineral production. 20% of world tourism spending is linked to China, both inward and outward, with the Japanese economy predicted to experience a £17.3bn cost from the virus. Cathay Pacific, a Hong Kong based airline, has asked 27,000 staff to take a three-week unpaid holiday while, in the UK last year 415,000 visitors from China spent £714 million in UK hotels, shops, restaurants, etc. One estimate in the newspapers suggests every 22 visitors from China to the UK creates an additional job.

China now accounts for 13% of world trade. Wuhan, the region where the outbreak started, is prominent in world car production. Honda, Toyota and General Motors have factories there and many of these are currently closed to prevent workers travelling to work and catching or spreading the disease. Similarly, many shops are closed and Chinese branches of Western stores, particularly luxury products, such as Burberry, Estee Lauder and Canadian Goose have talked of falling sales in China as Chinese citizens stop shopping for such luxuries and the number of foreign tourists to China drops significantly. Ralph Lauren has closed 55 of its 110 stores in China. China is the world’s largest oil importer, daily consuming as much as the UK,  France, Germany, Italy, Spain, Japan and South Korea, and, as China’s economy slows oil prices have dropped with analysts comparing it to the fall as a result of the financial crisis

Apart from direct effects, China factories have a major impact on world supply chains, assembling products and producing components from everything from cars to iPhones. Fiat Chrysler, the Italian-American carmaker, has said that it could shut one of its plants on the Continent if the disruption continues while Sony and Nintendo have both talked of unavoidable delays in the supply of some of their products.

As Chinese production slows and both its exports and imports decrease, world growth will fall. Whether this is a temporary blip or a permanent drop will depend on how serious the epidemic turns out to be. However there is an upside – in China demand for  contraceptives and  Netflix subscriptions are both booming.

Brexit – The Sequel

The UK has been on a long journey since voting to leave the EU three and a half years ago. According to some, we are in the departure lounge waiting to start an exciting voyage while, for others, we are standing on the cliff edge. So what is in store for the UK?

By Monday, our Members of the European Parliament will have lost their jobs and there will be a new 50p commemorative coin but little else will have changed since we will be in the transition period, currently scheduled to finish at the end of the year. This means that for eleven months we will be keeping to EU rules, following its treaties, and paying into and receiving grants from the EU budget. During this period, we will be negotiating with the EU to establish the trading arrangements which will come into effect in 2021.

The Government will have some difficult decisions to make – many leavers are looking forward to being free from the EU’s regulations while many areas of the country which switched from Labour to Tory in the recent election rely on industries being able to export to the EU and therefore need a deal which agrees an alignment between UK and EU standards. Parts of these areas are dependent on the motor industry which did not enjoy a good 2019. Car production in the UK fell last year by 14% down to 1.3 million, the lowest level for ten years and the third consecutive year of decline. The industry has put this down to a move away from diesel cars and falling demand in some of our major markets, such as China. Many plants are producing significantly below capacity, e.g.  the Vauxhall Astra plant in Ellesmere Port can produce almost 200,000 cars a year but, last year, produced only 61,000. The EU accounts for 55% of our motor exports and, last year, their demand fell 11%. A deal which limits our exports of cars to the EU will have significant consequences and a Government paper suggested that the North West, the North East and the West Midlands would see a fall in GDP of 16% if no deal is reached.

The motor industry is not the only one where the nature of the deal (if one is agreed) will be significant. The fishing industry, with annual exports to the EU of almost £1 billion, is pressing the Government to limit the access of EU boats to UK waters while the financial sector, which exports £26 billion to the EU annually, is keen to maintain its access to EU financial markets. There is comment in the newspapers about bankers being sacrificed for fishermen and it will be hard for the Government to satisfy both parties.

The service sector is becoming increasing concerned about talk of a Canada style agreement (CETA – Comprehensive Economic and Trade Agreement) because that agreement between the EU and Canada concentrated largely on goods, while services make up 80% of UK GDP. It is not clear that the EU will be wiling to offer the same agreement to the UK as to Canada. Because we are geographically much closer to the EU than Canada is, the EU is more concerned about the UK being used a backdoor into the EU by third parties. They are also keen to ensure that the UK observes the same regulatory standards as the EU so we are not able to undercut EU producers because, for example, of generous assistance provided by the UK Government or weaker environmental standards.

Finally, remember that took the EU and Canada seven years to agree CETA and we have eleven months.

Does the balance of payments matter?

In the last four years, the deficit on the current account has averaged between 4% and 5%, but during that period  we had a six month period when the deficit on goods and services (a key part of the current account) averaged 7% of UK GDP while predictions are that there was a surplus for the last six months of 2019. The last time this happened was over 20 years ago. For 2019 as a whole we might be talking about a deficit averaging 1.5% of GDP. However, there has been a major change in the composition of our balance of payments;  our manufacturing sector has declined significantly and its contribution to the balance of payments has been negative. Despite falls in the value of sterling particularly in 2008 and after the Brexit vote, manufacturing failed to thrive as predicted, even after the “J curve effect” which suggests a time-lag between a fall in the value of the currency and an improvement in the balance of payments. Possibly this was because of low UK productivity, poor growth among our main trading partners, limiting their demand for our goods, or  because UK producers opted to keep prices the same in foreign currency, therefore increasing their profits. Fortunately, the manufacturing deficit has been partially offset by our service industries where we have a comparative advantage.

Both The Times and Financial Times have printed articles about the decline in the importance of the balance of payments. Their articles refer to the time when newspapers published the balance of payments figures on the front page and the data would be prominent on the television news. Economics students would rank the balance of payments as one of the country’s main economic objectives while today, they struggle to remember what comes after low inflation, low unemployment and high GDP growth. One reason for the decline in the attention given to the balance of payments is that the figures are recognised as sometimes being inaccurate and also likely to be influenced by special factors, such as the way the deficit increased in the run-up to Brexit because businesses built up stocks in case of disruption while, more recently, a partial cause of the improvement in the balance of payments has been the run down in these stocks.

So does a persistent deficit matter? A sustained deficit implies a leakage from the circular flow of income, has implications for living standards and might be a sign that the economy is underperforming since it is selling few exports and buying too many imports.  It might also lower the exchange rate with implications for inflation and living standards since imports will become more expensive.

If a deficit is driven by over-consumption, possibly financed by high levels of debt and inadequate savings, then a persistent balance of payments gap is evidence of serious distortions within the economy. (A deficit can be good if a developing country is importing capital and new technology). According to the IMF “When a country runs a current account deficit, it is building up liabilities to the rest of the world that are financed by flows in the financial account. Eventually, these need to be paid back.”  Their view comes from the way a current account deficit must be financed which involves a surplus on the financial account. This means  that overseas individuals, banks and businesses will be carrying out activities which bring money into the UK. These would include foreign millionaires buying property in London, either to rent or live in, foreigners buying UK company shares or putting money into UK banks or foreign companies building new factories in the UK.  The UK is fortunate that it is an attractive place for such transactions. We have a sound legal and financial system, clear property rights and, currently,  membership of the EU single market, making us attractive to non-EU businesses so we have been able to finance the deficit without difficulty.

If our attractiveness falls, then the situation could change, with depreciating sterling, since the demand for it from foreigners buying UK exports or depositing money in the UK will be smaller than its supply on the foreign exchange market as we try to buy imports or higher interest rates to attract money from overseas with undesirable consequences for the domestic economy.

 

 

 

 

 

 

Purchasing Power Parity and the Big Mac

According to the Purchasing Power Parity (PPP) Theory of exchange rates, currencies should adjust so that the prices of a similar basket of goods costs the same in different countries and is used to examine whether a currency is currently over or under-valued. If the current exchange rate between sterling and the US dollar is £1 = $1.50, we would expect that if a  basket of goods  cost £100 in the UK  it should cost $150 in the USA .  However, if the basket only cost $100, travellers from the UK to the USA would find that their pounds, when converted into dollars, were buying more in New York than they could purchase in London and sterling was overvalued.

The PPP exchange rate is also used when comparing living standards in different countries. GDP per capita is the most common method but there is a problem with the exchange rate. The UK GDP is measured in sterling while the US uses dollars. If the exchange were stable AND reflected the prices of goods in the two countries, there would not be a problem. However this is not the case. As an illustration, consider that the £:$ exchange rate has fluctuated between £1 = $1.49 in 2016 and £1 = $1.25 in 2019. Depending on when one made the comparison, it might look as if the UK standard of living had fallen significantly over the three-year period. Therefore, using a PPP exchange rate, which uses the cost of similar baskets of goods, avoids the problem of a fluctuating exchange rate.

The use of PPP exchange rates can have a significant impact when looking at a country’s income. In India, the predicted GDP per head for 2020 rose from $2,500 per person to $8,900 when a PPP measure was used, indicating that goods and services there were cheap and the Indian rupee was significantly more valuable than indicated by the exchange rate  while in Norway predicted GDP per head fell from $79,000 to $69,000, showing that goods are services in Norway were relatively expensive.

However  PPP’s use brings different problems. Calculating the cost of a comparable basket of goods is a complex process  – think what you might have for breakfast at home compared to what you would eat in France. Since 1986 The Economist has published its own, non-scientific, PPP measure based on the price of a Big Mac in different countries. (An alternative to the Big Mac particularly in countries where the eating of beef is not common is the Starbucks Grande Latte Index). The Big Mac Index is useful as a quick guide to whether or not a currency is over or under-valued. Last year a Big Mac cost $5.58 in the USA but SFr6.50 or $6.62 indicating that the Swiss franc was overvalued by almost 20%. However if you wanted to fill up on Big Macs, the best place would have been Russia where it cost 110 roubles or $1.65, showing that the rouble was significantly under-valued.

The PPP is not an accurate predictor of short-term changes in exchange rates since speculation and interest rate changes can move currencies quickly. However, over a long period, the concept is valid. According to The Economist, currencies which, according to the Big Mac Index, were undervalued, appreciated over a 10 year period and vice versa.

The WTO Today

The World Trade Organisation was established in January, 1995 to promote free trade and support the generally-held view that such trade provides benefits in the form of greater choice and lower prices, stimulates economic growth, raises incomes and promotes world peace. Since the WTO was founded, world trade has grown from 41% of world GDP to 58% in 2017. Any country wishing to join the WTO must accept all its rules, particularly the  ‘Most Favoured Nation’ agreement whereby countries  must apply the same tariff to similar goods, irrespective of the exporting country, unless there is a free trade agreement between the importing and exporting countries. Thus if we leave the EU without an agreement, the EU will apply the same 10% tariff on UK car exports into the EU as it does to those coming in from other non-EU countries. Similarly, if the UK government were to announce a unilateral move to zero tariffs on agricultural products from the EU, without a trade deal, we could not levy tariffs on agricultural goods from elsewhere.

The WTO also acts as a forum for negotiations to reduce tariff barriers,  provides technical assistance for developing countries and  helps to resolve trade disputes between its 164 members with judges appointed to deal with disputes. Its role in negotiations has become less important because the size of the body makes agreement difficult but dispute resolution has become increasingly important, with the WTO being the place countries turn to after negotiations have failed. If, after investigation and consultation, the WTO court believes a country has broken its rules, it can authorise retaliatory tariffs. For example, the USA has been in dispute with the EU over subsidies to Airbus which made it more difficult for Boeing to compete and the EU was found to have acted unfairly.  The USA has also had wins in the WTO court against China which it accused of stealing intellectual property and subsidising domestic industries. However it has also lost cases in the WTO court, particularly over its use of tariffs to protect US producers against competition which it regards as unfair. The loser in a case must change their practices or the WTO can allow the victim country to impose retaliatory tariffs to cover the damage inflicted.

However, at present, the WTO is in crisis. It has seven judges who adjudicate on cases referred to it and must have a minimum of three in every hearing. Because it has been unhappy with some recent decisions, the USA has refused to agree the appointment of replacement judges to replace those who have retired and, from last month, the WTO court only has one judge (ironically from China) so does not have enough judges to hear cases (although two who retired in December are staying on to complete cases already started).

Even though many countries, apart from the USA,  are not happy with the WTO, with complaints about the its system for settling trade disputes which they say takes too long and the WTO’s inability  to  deal with China with its mixture capitalism and state control, there is a fear, particularly among smaller countries, that if the WTO ceases to function, power will revert to larger countries such as the USA and China which will have the power to bully smaller countries into accepting unfair trade deals.

UK exports,  the falling value of sterling and global supply chains

Since the referendum in 2016, sterling has fallen from £1 = 1.27 euros to 1.18 euros today and from $1.45 to $1.31.

Traditional economic theory predicts that a fall in sterling will lead to an increase in the quantity of exports and, as long as the percentage increase in quantity exceeds the drop in the value of sterling, then the value of exports will increase. This will not be immediate because demand for exports is inelastic in the short term, as it takes time for UK exporters to pass on the fall in price and for foreign buyers to appreciate it. Even if UK firms do not cut prices in overseas markets, the higher profits they are now receiving from exports should encourage them to devote more resources to their export markets.

Therefore, since sterling has fallen by 12% since 2015, we should, by now, be experiencing a significant improvement in our export sales. However they have not generally responded as hoped. A key reason for this has been the development of highly integrated supply chains.

If one thinks about the processes involved in manufacture, the first stage might be  design, then raw materials will need to extracted and refined, then components  need to be manufactured, the whole product assembled, then packaged, marketed and, at each stage, transported along the supply chain. In today’s economy, the number of firms solely responsible for the manufacture of their goods is tiny and, for products with thousands of components, the process will be extremely complex, involving goods crossing borders many times.

After a fall in the value of sterling, the price of all imported raw materials and components will increase, as will the cost of fuel needed to transport components and the finished product. Therefore, exporters will find that, rather than being able to cut their prices by the full extent of the drop in the value of the currency, they will have to take account of the higher costs of their imported components and raw materials, thus reducing the beneficial impact of devaluation.

A second factor in recent years has been an increase in the importance of non-price factors, such as marketing, reliability, the ease of obtaining spare parts and delivery dates. Therefore price elasticity of demand has become less important.

Ironically, the UK companies gaining the most from the fall in sterling have been those with significant earnings overseas since these, when converted into sterling, are now worth more.

The 2019 Nobel Prize

This year’s Nobel Prize has been awarded to Abhijit Banerjee, Esther Duflo (only the second woman to be awarded an economics Nobel prize) and Michael Kremer  for their new approach to investigating the most effective ways of  alleviating global poverty in developing countries.  They use experiments to determine the most effective ways of reducing poverty.

In the words of the Awarding Committee,  “one of humanity’s most urgent issues is the reduction of global poverty, in all its forms. More than 700 million people still subsist on extremely low incomes. Every year, around five million children under the age of five still die of diseases that could often have been prevented or cured with inexpensive treatments. Half of the world’s children still leave school without basic literacy and numeracy skills.This year’s Laureates have introduced a new approach to obtaining reliable answers about the best ways to fight global poverty. This year’s Laureates have introduced a new approach to obtaining reliable answers about the best ways to fight global poverty. In brief, it involves dividing this issue into smaller, more manageable, questions – for example, the most effective interventions for improving educational outcomes or child health.”

In the past economists used a macro approach to analysing different policies. Therefore, for example, they might observe that a fast-developing economy spent more than others on teachers and books and gave parents money to encourage better attendance in schools. However, they would not have been able to provide an answer to the question of which of these measures was the most effective. What the three Nobel prize winners did was to promote the use of small-scale experiments; for example this might involve one group of randomly-selected schools having more teachers, another group receiving money for text books and a third group giving parents money as a reward for their children’s attendance. By examining the effects of these three experiments, it would then be possible to identify which policies had the greatest impact. They  also used their experiments to investigate why particular policies work well and others do not and therefore to apply their findings more widely. As a result of their work, these sort of experiments have now become common, particularly in the field of development economics.

One such experiment  was to discover the best way to encourage vaccinations of children so they set up a control group of villages, who would have had to travel to a nearby town for vaccinations, a group where mobile vaccination centres visited and a third group where not only did mobile vaccination centres visit but those vaccinated received a payment in the form of lentils (a vegetable). The three groups of villages were in the same region and were selected at random. The result of the trial was that 6% of children in the control group were vaccinated, while 18%  of children in the villages receiving the mobile centres and 39% of children in those also receiving the lentils were vaccinated. The trial also demonstrated that, per child vaccinated, the lentil incentive had such a large impact that it was significantly cheaper per vaccine than just having a mobile centre visit ($28:$56).

The prizewinners have, according to the  Nobel Committee “completely reshaped” the way economists now test policies and they have therefore had a major impact on economic development.

 

 

How is the UK doing?

In the run-up to a big boxing or tennis match, the media is fond of making comparisons between the two competitors, comparing key measures such as height, weight and reach. As we approach Brexit on 31st October or later,  it is worth doing the same exercise for the UK and world economies to see what state the UK is in.

Optimists, looking at data published in August, highlight the increase in average earnings of 3.6% in the year to June, the highest increase since June 2008, the rise in employment to 32.8 million (largely due to increased females working), giving the joint highest participation rate ever.

However pessimists focus on the fall in GDP of 0.2% from April to June, the sharpest fall in high street sales since December, 2008 (although these are survey figures, so might not be representative) combined with a fall in internet shopping, the increase in inflation to 2.1%, the small increase in unemployment to 3.9%, the lower than expected government budget surplus and the balance of payments current account deficit amounting to 5.6% of GDP. They also worry about the quality of some of the new jobs being created, possibly on zero hours contracts, and ask whether the rise in employment is because firms are reluctant to commit themselves to expensive investment projects because of low confidence in the economic outlook.

The current state of the world economy is also a concern for the UK. Germany suffered a fall in GDP in the last quarter and is expected to move into recession (two consecutive quarters of negative growth), the trade war between the US and China is dragging on and growth in the latter is slowing, and the International Monetary Fund has cut its forecast for world growth to 3.2%, the lowest for ten years. The world economic situation has been a key factor in last month’s fall in UK manufacturing output – the fastest rate of fall for seven years. However, worryingly, another explanation provided was that some foreign firms are cutting the UK out of their global supply chains in anticipation of Brexit (but bear in mind that manufacturing is now only 10% of UK GDP).

However what was a feature in the news last month was the technical concept of an inverted yield curve. The yield on a financial asset, such as a government bond, is the rate of return based on its purchase price and, normally, it is higher for long term assets than short term ones. If the government borrows money for three months, the rate of interest would normally be lower than if it borrowed for ten years. This is because lenders are rewarded for committing their money for a longer, and therefore riskier, period. When this is reversed, i.e. governments can borrow at a lower rate of interest for ten years than one or two, it signals that the markets expect that the future will be poor and the government will cut short-term interest rates in the future, therefore savers will wish to lock into the current long-term rates of interest. An inverted yield curve also shows that savers wish to lock into safe assets, such as US, German and UK government bonds, and are prepared to pay a higher price for them. The higher price reduces the yield from the bonds. An additional concern is that current interest rates are already at very low levels so the scope for reducing them is limited so, despite concerns about high government borrowing, fiscal policy might be the only weapon left.

Bicycle Wars

The trade war between America and China rumbles on, confused somewhat by the recent actions which the US has taken over the involvement of Huawei in technologically-sensitive areas of the economy. The use of tariffs to protect industries involved in areas of national security can be justified by WTO rules. President Trump has been free in his use of this justification He has used it to justify tariffs on steel since it is an important product for the defence industries. His use of the argument that he has to protect strategic industries suffers when he simultaneously talks of the need to reduce the “BAD” US balance of payments deficit, which, according to him is the fault of foreign countries and not due to a lack of competitiveness among US industries.

Another more long-term example was highlighted by The Economist in a recent article about bicycle exports from China to America. (The same article also provides an insight into of the workings of global supply chains.)

In the 1970s, the vast majority of bicycles sold in the USA were made in the USA – around 15 million. By the late 1980s, US producers were suffering from Chinese-made bicycles entering the American market very cheaply and then, suffering even more when the Chinese producers further cut their already-low prices to drive out domestic US production – an example of dumping. Remaining US producers sought anti-dumping tariffs but the US government was more interested in good relations with China and did not act.

Some bicycles are still made by a US firm – BCA, the Bicycle Corporation of America, which was launched when Walmart decided to operate a Buy-American campaign. However BCA is now a subsidiary of a Chinese firm, Kent, (previously a US family firm which was half bought by a Chinese firm) and, furthermore, BCA only assembles in the USA, it buys its parts from a Kent factory in China.

Last September bicycle prices were raised by 10% tariffs and a further 15% tariff was imposed in May, hitting US consumers.

What right did President Trump have to do this? He used a US government power – section 301 – which allows the US government to protect intellectual property. How does this apply to Chinese bicycles?