In January I attended a presentation by Valentina Bruno of the American University in Washington DC and Hyun Song Shin of The Bank of International Settlements (BIS). This presentation was given in Philadelphia.
The presenters argued that global value chains (GVC) figure prominently in global trade. GVCs lie at the intersection of two important themes. The first is the financing requirement for working capital. The second is the prevalence of dollar invoicing in global trade. The result of the interaction of these two themes, is that the dollar exchange rate emerges as a determinant of GVC activity.
Specifically, this means that "a stronger dollar is associated with tighter credit conditions and subdued GVC activity." Surprisingly, this means that exports from emerging economies may fall when their currencies fall against the US dollar.
Listen to the podcast
The theme of the presentation was the close relationship between variation in the US dollar and the exports of emerging economies. It appears that 82% of trade of emerging economies is financed in US dollars. It was argued that there was "mismatching" of US dollar exposure by emerging economies. This means that US dollar exposure held by emerging economies was essentially unhedged.
In theory this would suggest that if emerging economy currencies rose against the US dollar, then there would be a greater volume of funds available to finance exports and imports of US dollar denominated products in developing economies. Turns out this is also true in practice. The presenters showed charts demonstrating that the finance available to finance the trade in manufactured products made by emerging economies rose as the US dollar fell, and fell as the US dollar rose.
This increase in finance had a direct result on the real volume of trade by emerging economies. They noted that it was particularly apparent when one used the Bank of International Settlements (BIS) "broad" US dollar index which includes the currencies of many developing economies. Although this was still apparent when one used the Bank of International Settlements narrow measure of the US dollar index including only major economies; statistically the relationship was much stronger when one used the BIS broad US dollar index.
I have found that a similar relationship to that between the broad US dollar index and the manufactured product trade of emerging economies exist for the commodities trade of emerging economies. Quite simply, as the broad index of the US dollar falls, the volume traded and the price of commodities produced by emerging economies rises.
As the broad index of the US dollar rises, the volume and the price of commodities produced by emerging economies falls. This is not simply a direct currency pricing effect. As the US dollar falls, the amount of finance available to finance the international trade in commodities produced by the emerging economies rises. Thus the volume of exports of commodities by developing economies rises. The price rises too. Why is this important?
We are entering a period where the US budget deficit is increasing. This budget deficit is increasing in order to finance the core programs of the incumbent Republican Party. The major tax reforms passed by the Republican Party in late 2017 are resulting in a larger US budget deficit. Increased military spending passed by the US Congress in a bipartisan bill in early 2018 will further increase the US budget deficit.
An increase in the US budget deficit will generate an increase in US demand. An increase in US demand will generate a larger US current account deficit. An increase in the US current account deficit will generate a lower US dollar. A lower US dollar will generate an increase in the volume of finance available to finance the commodity exports of emerging economies. The volume and price of internationally traded commodities will rise.
The increase in the US budget deficit required to finance the Republican legislative programme will have far reaching effects. The US dollar will fall. The volume of international trade in manufacturing and commodities will rise. Commodity export volumes and commodity export prices will go up.
The outlook for Australian commodity exporters may be greater than we think.
View more analysis from Michael Knox by clicking on 'economic strategy' in the popular topics list to the right of this page, or listen to his full playlist of podcasts on SoundCloud. Alternatively, contact your Morgans adviser or nearest Morgans branch.
Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents ("Morgans") do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.