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. . . .