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.

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.

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?

Sterling and the UK Economy

The pound has undergone something of a roller-coaster ride over the past three and a half years.  It was $1.71 in July 2014, fell from $1.49 to $1.32 after the Brexit vote and then again to $1.21 in January, 2017 and has recently risen to $1.38 (20th January 2018). However, it is worth noting that while, historically we usually measure sterling against the dollar, the fall against the euro has been greater.  In July 2015, £1 would buy 1.49 euros but by August 2017 the rate had fallen to £1 = 1.08 euros  and it is currently at £1 = 1.33 euros.

This post will consider the factors which might cause the value of a currency to fluctuate. (and the next will discuss the impact fluctuations might have on an economy). Over the last 100 years, the world has moved from a system where currencies were fixed to gold (the Gold Standard), to a time when the dollar was fixed to gold while currencies such as sterling were pegged, with limited flexibility, against the dollar (the Bretton Woods Agreement) to a system of flexible exchange rates where, today, in theory, the demand for and supply of the pound in the foreign exchange market determines its value.

In old economics textbooks, the adjustment process was simple.  The demand for a currency is determined by foreigners wanting to buy UK exports and needing to pay for them in sterling while the supply of sterling came from UK firms and consumers wanting to buy foreign goods and services, such as overseas holidays, and needing to swap pounds for foreign currency to pay for them. If the UK had a balance of payments deficit, the demand for sterling in the foreign exchange market would be less than the supply and so the value would depreciate against other countries, making UK exports cheaper and imports more expensive, restoring international equilibrium.

Today the situation is far more complex; not only do we have to consider the impact of a currency such as the euro which has replaced the individual currencies of the members of the eurozone, making it impossible for them to use depreciation to improve their balance of payments, it is now no longer the sale and purchase of exports and imports of goods and services which determines  the exchange rate, it is the trade in financial assets which is far more important as banks, businesses, governments and individuals buy and sell foreign shares and government securities and move money between countries to gain higher interest rates or profit from speculative movements in currencies. To put this into perspective, the World Trade Organisation estimated that in 2015, total international trade in goods and services amounted to $20 trillion while $5 trillion was traded on the foreign exchange market EACH Day.

Therefore factors which influence speculators’ views of the economy will have a major short-term impact on the value of the currency. Hence, immediately after Brexit, the general view was that leaving the EU would have detrimental effects on the economy (or at least on those dealing in financial assets and currencies) and this reduced the demand for sterling from overseas and increased its supply from UK holders seeking to purchase foreign financial assets. Similarly if the political situation changes and that affects views of the economy, then the value of the currency will change. Other things which will affect the value of the currency will be changes (or expected changes) in our rate of interest or the rate of interest in other major currencies, the economic performance of our economy or other major countries since if, for example, the US economy weakens, then relatively, the UK economy will be stronger and this will encourage a movement of money from the dollar to the pound.

The WTO & Brexit

The World Trade Organisation has not featured  frequently in UK newspapers since its foundation in 1994. However since the Brexit vote, there has been increased interest in its role in regulating world trade  since, if no agreement is reached, the UK might be falling back on WTO trade rules following departure from the EU. Its aim, when it replaced its predecessor, the General Agreement on Tariffs and Trade (GATT), was to act as a forum for negotiations to reduce tariff barriers,  resolve trade disputes between members and provide technical assistance for developing countries.

GATT was established after the Second World War to ensure that there was no return to the protectionism which  took place in the 1930s as countries tried to protect their economies from the effects of the Great Depression. The WTO replaced GATT because of  developments in international trade since the Second World War, namely the rise of intra-firm trade where a company manufactures components in one country, assembles in a second and sells in a third, increased globalisation and the rise of trade blocs, such as the  EU, and NAFTA. It can authorise sanctions if a country breaks its rules. For example, in 2015 it ruled that the USA had acted illegally in insisting that all beef and pork sold in the USA should have the country of origin labelled. Canada, which sells much meat in the USA, applied to the WTO to impose retaliatory tariffs which will hit many different parts of the US economy in order to persuade the USA to reverse its requirement.

As well as regulating international trade, the WTO attempts to promote free trade since it believes that freer trade provides benefits in the form of greater choice and lower prices, stimulates economic growth, raises incomes and promotes world peace. It does this  via a series of meetings (or rounds) lasting many years, the latest being the Doha Round, which started in 2001, lapsed at the end of July, 2008 as trade fell due to recession, and has now been revived. But its success in reaching agreement is limited and has moved towards agreements covering specific products e.g. removing tariffs on high-end semi conductors rather than wide-ranging agreements which have been difficult to reach.

Anyone wishing to join must agree to 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 Malaysia.

Another concern is that WTO rules do not reduce regulatory barriers. At present, because of the Single Market, a UK car manufacturer can sell products as easily in Rome as Romford. This will cease if there is no agreement with the EU and therefore we would expect our lorries to be stopped when entering the EU and inspected, in the same way that British goods entering  Japan are currently examined. This has the potential to hinder  trade as lorries are inspected and goods checked to ensure that they meet EU standards. This might not seem a major problem but exporters fear that these delays will be significant, delaying drivers and lorries and therefore increasing costs.

A third concern is that WTO rules do not currently provide as much freedom for trade in services as they do for trade in goods. At present, for example, UK banks provide services for individuals, businesses and other banks across the EU without needing to duplicate all of their physical locations overseas. Leaving the EU will make trade in services, which make up 80% of the UK’s GDP, far more difficult and might require UK financial consultants, bankers, accountants, etc to  have more physical locations overseas and also to re-qualify in the countries they export to.

It is difficult to predict what the effects on our trade will be until the Brexit agreement is reached. As part of the EU, we currently benefit from free trade treaties between the EU and other countries and we do not know whether we will be able to negotiate to keep these agreements. Equally, or possibly more importantly, we do not know what tariff and non-tariff arrangements will be in place between ourselves and the EU when we leave. Will UK consumers lose out because of  higher priced imports  from the EU or will these be outweighed by new trade deals negotiated by the UK with non-EU countries and will UK businesses see exports rise because of these new agreements or fall because of less trade with the EU?

 

 

 

World Bank admits some have lost out from free trade – BBC News

An internal document seen by the BBC says globalisation “may have led to rising wage inequality” as the head of the World Bank says more needs to be done to help those who have lost their jobs.

Source: World Bank admits some have lost out from free trade – BBC News

The Role of Trade in Supporting Growth and Reducing Poverty – World Bank

World Bank here, highlighting the benefits of trade to the masses. Good for examples to use in your essays relating to trade and globalisation.

Globalisation benefits us and the majority of the world – but can it be tamed? | The Independent

They say that when elephants fight the grass gets trampled. And when economists fight over elephants the complex reality can come off worse too. A few years ago the World Bank economist Branko Milanovic produced a profoundly influential chart showing the change across the global income distribution (running from the poorest people on the planet to the very richest) over the past 30 or so years. The pattern was striking.

Source: Globalisation benefits us and the majority of the world – but can it be tamed? | The Independent

Trade in the balance | The Economist

Globalisation can make everyone better off. That does not mean it will

Source: Trade in the balance | The Economist

Thanks To Rob P.

An insightful discussion regarding the merits of globalisation and trade, including some very useful evaluative points concerning stakeholders and regional disparities in benefits and costs. Well worth a read for the current A2 group.