The 'Fragile Eight' and Terms of Trade

Another day, another warning of possible global implosion. This time it's from the Geneva Group: as lofty a  bunch of European financial and economic practitioners as you're likely to come across. Entitled 'De-leveraging, What Deleveraging?' the report is for the most part a detailed explanation of why high levels of indebtedness can be dangerous. It also attempts to identify the difference between simple recessions and various types of debt-triggered disasters (an attempt which hinges on a touching faith in the ability to identify 'potential GDP'); and finally it focusses on the build-up of debt in emerging markets, warning of the possibility that the next financial crisis may be bubbling up in China and/or a group they identify as 'the Fragile Eight.'

The 'Fragile Eight' are: Argentina (129% debt/GDP in 2013); Brazil (121%); Chile; India (120%); Indonesia (65%); Russia (43%); South Africa (127%) and Turkey (105%).

In this article, I'm going to ignore China, and instead focus on the 'Fragile Eight'.  Or rather, I want to focus on one of the key factors which can turn an underlying fragility into a genuine crisis. the Geneva Group identifies three main types of crisis: banking crises; sovereign debt crises; and external crises, which they describe as an inability to rollover existing debt or obtain funding to cover current account deficits.  But each of these need a trigger - a shock which catalyses the crisis, of whatever type it may be. And in my experience, one key trigger which is almost always present, but which almost always gets ignored until it's too late, is a deterioration in a country's terms of trade - ie, a rise in import prices it must pay relative to the export prices it can command.

Big shifts in a country's international terms of trade really matter.  In terms of debt crises, they matter particularly because;
i) in practical terms, a deterioration in terms of trade usually results in a deterioration in underlying cashflows within an economy, which in turn  can expose latent financial vulnerabilities both to, and within,  a country's financial system;
ii)  since a country's terms of trade signal an international ability to price its goods and services, it is also a reflection on its potential growth rate. Put simply, if a country's terms of trade are rising, the world wants what it has to offer; conversely, if they are falling, the world's appetite for its goods and services are in relative decline.  And, of course, even though experience warns us that attempts to pinpoint a country's potential growth with any useful accuracy usually fail, a shift in the terms of trade is a useful indicator of which way the wind is blowing.

For each of the Fragile Eight, I have looked at movements in the Citi Terms of Trade Index since the beginning of 2006, and tracked where September's index is relative to the long term average, and also at the change during the last 12 months.  In both cases, I'm interested in both the extremity of the current position, and in the speed at which changes have happened.  In order to capture this, I have expressed the current deviation in terms of standard deviations from the post-2006 average.

This table reveals the Fragile Eight are not as coherent a group as the Geneva Report assumes.
i) For Turkey, Russia and India, the story told by the terms of trade are either positive or neutral, with the implications for improved cashflows that implies. These are the the Not-So-Fragile Three.
ii) Conversely, there are two, and possibly three, clear losers. Brazil is the biggest loser both in terms of how far from the post-2006 average September's position  has fallen (2SDs below) and the speed at which this fall has occurred (2.3SDs over the last 12 months).  South Africa and Indonesia also look like major losers, with Indonesia's terms of trade currently 1.7SDs below its l/t average, and South Africa's 1.4SDs below. Of these two, however, South Africa looks the more vulnerable, because it starts with a much higher leverage (127% of GDP vs Indonesia's 65%), and because Indonesia's terms of trade appear to have virtually stabilized over the last 12 months, whilst South Africa's has deteriorated quite sharply (down 0.5SDs).
iii) Finally, whilst both Argentina and Chile are suffering a modest deterioration in terms of trade, the current position and the speed which which current deterioration has arrived look relatively unexceptional.

Finally, it is worth remembering that terms of trade are a global zero-sum game: one country's terms of trade loss is another country's terms of trade gain.  What may yet prove the most important factor in the world's cycle is the unusual strength and resilience in terms of trade which developed markets are now showing. This phenomenon embraces not just the US and Europe, but also most of Northeast Asia, including economies who's histories have for years or even decades been suffered incessant terms of trade problems.  More on that later. . . .  

Eurozone - Expansion Despite Policymakers Best Efforts

There are very good reasons why the Eurozone is identified as a major drag on the world economy: its policymakers have managed to distil a formula of strategic policies which are fundamentally toxic.  The mix tightens fiscal policies whilst at the same time demanding bank recapitalization, all within a single-currency framework which imposes on approximately half the continent the wrong international pricing for locally-produced goods and services.  The resulting slide towards deflation isn’t an accident, it is policy (sometime referred to as ‘internal devaluation). To that must be added a studied lack of enthusiasm for supply-side reforms, and in certain cases (Italy, Spain, Portugal at least) an inherited public sector debt problem which, without a return to vigorous nominal GDP growth, must eventually end in default.

None of this is news to those outside the policymaking environs of the EU.  What is more surprising is that the Eurozone continues to grow at all (albeit 2Q GDP was virtually unchanged qoq, annualizing to just 0.1%), and might be expected to accelerate mildly over the coming year. And yet embedded in the misery, there are developments which would, in other circumstances, herald a cyclical recovery.  The good news shows up in rising productivity of the two key factors of production: capital and labour.

The first chart attempts to identify directional trends in return on capital by considering nominal GDP as an income from a stock of fixed capital. Movements in that capital stock are estimated by assuming a 10yr depreciation of all gross fixed capital formation (as identified in quarterly national accounts). The chart shows a pattern in which capital stock has been shrinking since the beginning of 2013, and is currently now shrinking around 0.6% a year in nominal terms.  Since nominal GDP is currently rising at approximately three times that rate, asset turns are rising sharply, which in turn generates a rise in return on capital.

This cyclical dynamic of capital spending stalling sufficiently to allow a rise in asset turns is a familiar feature of economic cycles, and the corollary of rising asset turns is, of course, a resurgence of investment spending. The problem is that elsewhere in the world,  in this cycle the gap between return on capital rising and capital stock beginning to be replenished has been extraordinarily long.  For example, in the US, the ROC directional indicator bottomed out in 2Q99, and recovered to its pre-crisis levels by 3Q10, but it took until 2Q11 for capital stock to stop shrinking.  And then the recovery has been exceptionally muted: by 2Q14, although the ROC directional indicator was at its highest since the early 1980s, capital stock was growing at only 2.1% yoy.   One can guess at the reasons for this relative dislocation between ROC and capital spending: a fundamental lack of medium-term commercial confidence; an underlying deflationary expectations; a failure financial intermediation. Whatever the reason, ROC may be rising, but it seems obviously premature to expect any sort of sustained recovery in Eurozone investment spending.

The news is less bad for the second factor of production: labour. The cyclical dynamic plays out in much the same way as it does for capital: in the early stage of a recession, employment falls sufficiently to allow labour productivity (deflated by changes in capital per worker) to rise. When productivity begins to rise, labour markets begin to recover.  And here the trends in the Eurozone are slightly encouraging: real output per worker, adjusted for changes in capital per worker, are rising at approximately 1.7% yoy (output per worker up +0.6% yoy, capital per worker down c1% yoy). And in response, employment in the Eurozone is actually rising, by around 0.5% yoy in 2Q. This rise in employment is currently concentrated in two economies: Spain (up 2% yoy) and Germany (up 0.8% yoy). However, there is no reason not to expect this employment gain to be maintained, and gradually strengthened. In both the UK and (to a lesser extent) the US, the sustained rise in employment, backed by rises in labour productivity (deflated by capital stock) has been the key to the sustained and generally non-cyclical expansions currently underway.   And this is the key, the Eurozone’s recovery, though tepid, is unlikely to show signs of becoming self-supportingly ‘cyclical’ any time soon. 

Two final charts illustrate the point. The first is of the Eurozone’s private sector savings surplus: this I estimate at approximately 5.2% of GDP in the 12m to 2Q. The private sector savings surplus shows, of course, the balance between private investment and savings, and self-evidently, strong changes in the balance of these decisions are a key dynamic of investment cycles. Hence in 2008-2009 the financial crisis produced a very sharp jump in the PSSS from a savings surplus of around 0.7% at end-2007 to a high of 6.6% in  1Q10. The current dynamics are not similarly cyclical – since 4Q12 the surplus has wandered between 5% and 5.6% of GDP, and is currently drifting downwards, to around 5.2%: savings and investment decisions show no signs of dramatic movement.

The private sector savings surplus is also a measure of the fundamental vector of flows of cash between the private sector and the financial system – a savings surplus ends up as a net flow of private sector cash into the financial system, whilst a deficit will have to be funded by a flow of cash from the financial system to the private sector (for example, by bank lending and a rising loan/deposit ratio).  In a bank-dominated financial system, the positive flow of cash associated with a savings surplus will accumulate in bank deposits, and thus in the money aggregate M2.  It is therefore crucial to determine how effectively the banking system can recycle these savings back into the economy. One measure of this is monetary velocity (GDP/M2).  And as the chart shows this is showing a small but continuing decline.  Consider what this means: in the 3m to July, M2 grew at 2.3% yoy, and if monetary velocity continues to fade whilst monetary growth remains stable, nominal GDP growth must sink below the 1.8% achieved in 2Q14.

The ECB plainly understands the impact of the continuing inability of the Eurozone’s financial institutions to improve its recycling of private savings flows.  However, there is little evidence that even a fully committed policy of quantitative easing can reverse this fall in monetary velocity. In the US, all the Fed’s quantitative easing, coupled with a convincing expansion, has not yet managed to reverse the fall in monetary velocity. In the UK, quantitative easing has not stopped the long-term decline of M2, and, of course, in Japan, monetary velocity has been falling virtually without interruption since 1993.  The message seems to be that central largesse cannot make commercial banks into efficient recyclers of private sector savings – it can only attempt to overwhelm that inefficiency with sheer scale.

Where does this leave the Eurozone as a contributor to global growth in the short and medium term? Surprisingly, perhaps, leaves us with grounds to expect that a modest expansion can be maintained, despite the slowdown of 2Q, simply on the basis that rising labour productivity in the absence of net positive capital spending, will allow for a modest but sustained rise in employment, which in turn can provide some modest expansion in demand.   But there are two caveats: first, there is no reason to expect any obvious acceleration in pro-cyclical behaviour; second, there is no reason to expect that nominal GDP will match levels of M2 growth any time soon; and third, there is no reason to expect that any relatively modest steps towards quantitative easing by the ECB will succeed in inducing any pro-cyclical behaviour in the short to medium term. The Eurozone will remain a drag on world growth, but in the short to medium term, probably not more so than we are currently used to. 

This is an excerpt from the Shocks & Surprises Global Weekly Summary for the week to 19th September. Please email me if you would like to see a copy.