Below is a mindmap showing the causes and effects of a fall in the value of a currency. Also looks at how it improves the current account. Good for revision purposes when dealing with exchange rates and trade. Also gives a structure for essay questions / long answers in CIE and NCEA respectively.
The rhetoric around globalisation has been very much how beneficial it is to the global economy. Economists in general have been very much in favour of the interconnectedness of economies making goods and services more competitive to the consumer. So what are the pros and cons of globalisation?
On 7th April 2008 New Zealand became the first OECD country to sign a free trade deal with China, an economy which in the 1970’s was one of the poorest countries in the global economy. Today China is the world’s second largest economy and the fastest growing at a rate around 7% per year. China is now comfortably New Zealand’s largest export market, accounting for the largest share of our exports in all but a few sectors.
In 2017, China surpassed Australia and became our largest export market. But as exporters’ focus has switched to China, New Zealand’s exports have become less diversified, exposing exporters to concentration risk.
Westpac Bank reported in their November 2020 Quarterly Overview that while the New Zealand-China trade relationship is strong, China could in the future choose to disrupt New Zealand exports. Recently Australian exports into China had the following restrictions imposed on them:
80% tariff on Australian barley exports
ban on Australia’s biggest grain exporter
suspension of beef imports from five major meat-processing plants
China has also launched an anti-dumping investigation into Australian wine exports
Chinese cotton mills were told not to process Australian imports
At a high level, NZ-China trade flows reflect each economy’s comparative advantage and because of this trade relationship New Zealand faces less risk exposure. The risk exposure really depends on how important New Zealand’s export supply is to China and the other markets where the product/service can be sourced which includes other countries as well as domestically.
More Options = More Risk
China exposure risk by export sector
High risk It seems that tourism, seafood, and gold kiwifruit have the highest exposure. For these exports, essentially China has options (including domestically) for alternate supply. Education (universities and English language schools) also faces similarly high risk.
Also kiwifruit as New Zealand only account for 4.5% of China’s total fruit imports. China does have a competitive domestic horticulture industry which has started to grow Zespri’s Sungold kiwifruit variety.
Medium risk Wood and wider fruit sectors – have medium exposure risk. New Zealand accounts for a relatively significant share of global meat and wood exports, so China is reliant on New Zealand. Meat – China also recognises New Zealand as a reliable and safe exporter. Looking at the wider fruit sector, exporters remain relatively diversified and thus less reliant on China.
Low risk Dairy – in a strong position as China imports around 50% of its dairy produce from New Zealand. Wine – China is a small market for New Zealand, so the sector’s reliance on China is also small.
Overall the complementary nature of the NZ China trade relationship means New Zealand’s risk exposure is less than the outright level of exports would suggest. Chinaneeds New Zealand’s food (and wood) as it cannot produce enough (efficiently) on its own – while New Zealand remains the most competitive supplier. New Zealand needs China’s manufactured goods – while China remains the most competitive supplier.
Source: New Zealand’s exports to China: where is New Zealand most exposed? Westpac Economic Bulletin – 8 October 2020
I have blogged quite a bit on this topic and refer back to a very good video clip from PBS Newshour on how the Chinese authorities influenced the value of the yuan back in 2010.
Basically at 9.15am the Peoples Bank of China (Central Bank) and the SAFE (State Administration for Foreign Exchange) issues a circular to all the trading banks stating that this is the exchange of the Renminbi to the US$ for today. When companies sell goods overseas the US$ etc that they acquire are then exchanged for Renminbi with the Central Bank – therefore the Central Bank accumulates significant amounts of US$.
Today it could be said that China has done well economically relative to other countries largely due to its large trade surplus. However one would think that with a large trade surplus the yuan would increase in value as there is a greater demand for the currency in order to buy China’s exports. This raises the question as to whether China has been manipulated its currency in order to maintain its competitive edge in the export market.
When a country’s currency is getting too strong the governments/central banks sells its own currency and buys foreign currency – usually US$.
When a country’s currency is getting too weak the governments/central banks sells its foreign currency – usually US$- and buys its own currency.
For two decades until mid-2014 China’s prodigious accumulation of foreign-exchange reserves was the clear by-product of actions to restrain the yuan, as the central bank bought up cash flowing into the country. A sharp drop in reserves in 2015-16 was evidence of its intervention on the other side, propping up the yuan when investors rushed out. Since then, China’s reserves have been uncannily steady. This year they have risen by just 1%. Taken at face value, the central bank seems to have refrained from intervening. That is certainly what it wants to convey, regularly describing supply and demand for the yuan as “basically balanced”. Source: The Economist – “Caveat victor” – October 31st 2020
With the surge in China’s trade surplus the yuan has remained fairly stable and with this you would expect that there would be an increase in foreign exchange reserves with Chinese authorities buying foreign exchange with yuan.
A couple reasons why this may not be the case:
Commercial banks foreign assets have increased by US$125bn since April. The commercial banks are state owned so it is plausible that the government has used them as a substitute. Adding these foreign reserves to the offical figures suggests invention to keep the yuan at an artificially lower rate. There is the possibility that the central bank has special trading accounts at the state banks. Also exporters have wanted to keep their US$ as they are worried that the disharmony with the US could damage the yuan.
The central bank made it cheaper to short the yuan in forward trades – shorting a currency means that the trader believes that the currency will go down compared to another currency.
Chinese officials want the yuan to be volatile but within a narrow range in order to convince other countries that they are not intervening whilst persuading people in the market that they will intervene if necessary.
Caught between a rock and a hard place
The Peoples Bank of China (PBOC) are trying to protect domestic producers by keeping a weak yuan so to make Chinese products attractive to overseas buyers. At the same time they are trying to prevent domestic capital from flowing too quickly out of China to stronger currencies. However a longer term scenario is that China would like the yuan to be more prevalent as a currency in the global market. The yuan currently accounts for approximately 2% of global foreign exchange reserves, although by 2030 it is estimated that it will account for 5% to 10% of global foreign exchange reserve assets.
Source: The Economist – “Caveat victor” – October 31st 2020
Donald Trump’s subsidies to US farmers (see below) could be above what is allowed under international trade rules and it has been suggested that subsidies in 2020 will make up 36% of farm incomes.
US farm subsidies
2018 – US$12bn
2019 – US$16bn
This year US farm incomes are set to drop 15% even after the payment of subsidies and billions of dollars have been set aside to assist the farming sector. New Zealand officials are concerned that the subsidies given to US farmers will exceed the US$19billion which is the WTO’s limit. They want formal notification of payments in 2020 and how the US plans to reduce this assistance to farmers. The EU, China, India and China are asking similar questions of the US.
Subsidies distort trade and entice farmers to keep producing even though prices are falling – see graph . This output tends to be inefficiently produced and would not be competitive in a normal market free of subsidies.What the subsidies did in New Zealand was to encourage people to develop land that was not really suitable for any agricultural use. However as they got a subsidy from the government efficiency or quality didn’t feature as a major factor in maintaining competitiveness. With subsidies prices take longer to recover their former levels while excess supply is worked through as was the case in 2018 and 2019 when the EU dumped subsidised skim milk powder on the global market. But the support package to the US farmers is very significant and has the potential to negatively impact those countries that have unsubsidised farmers.
The Dairy Companies Association of NZ’s (DCANZ) executive director Kimberly Crewther says while other countries had propped up their farmers since the start of the pandemic the US was “way out in front” with the size of its support programmes. That was concerning given the growth trajectory the US dairy industry was currently on. “They have the potential to become the world’s largest dairy exporter, but that is going to come at a high cost to unsubsidised producers and not just exporters like NZ if that growth is coming from subsidies,” she said.
EU dumping has NZ Farmers lose $500m The dumping of subsidised skim milk powder (SMP) by the EU in 2018 is estimated to have cost New Zealand farmers $500m. In 2016 the EU moved nearly 25% of its production into storage before dumping it on the market in 2018 and 2019 at discounted prices. The purchasing of SMP by the EU was done with the intention of putting a floor price under the low EU farm gate milk prices. EU stocks – 378,000 tonnes in 2017 – 16% of global supply. Release of stocks onto the market had the estimated impact on prices:
2018 – SMP prices down by 3.6%
2019 – SMP prices down by 8.7%
US farm gate prices
2018 – SMP prices down by 1.7%
2019 – SMP prices down by 3.9%
The cost to NZ farmers is estimated at 30c per kg of milk solids in 2018 or 4.7% of the payout. The Eu was able to undercut competitors and increase its share of of the global SMP market from 30.6% in 2016 to 42.3% in 2019. New Zealand’s share fell from 23.5% to 16.3% over the same period.
Although in the CIE syllabus only three stages of economic integration are mentioned there are actually six stages between nations, ranging from the relatively weak to more complex and stronger associations.
1. Preferential Trading Area – weakest form of integration. Nations agree to give preferential access to certain products from overseas countries. The EU (European Union) and countries of the ACP (African, Caribbean and Pacific) have formed Preferential Trading Area.
2. Free Trade Area – most common type of integration. Nations permit an agreed list of products to be traded tariff free. However those nations can set their own tariffs between themselves and nations outside the agreement. EG. NAFTA, EEA and APEC
3. Customs Union – same as FTA but all member nations agree a set of standard tariff levels between themselves and outside nations. This is known as the Common External Tariff (CET).
4. Common Market – same as Customs Union but is more complex in that it involves the establishment of common laws relating to the economy, trade, and employment and a common form of taxation between member nations.
5. Economic and Monetary Union – one trade barrier that a Common Market does not eradicate is the presence of different currencies although Economic and Monetary Union does not necessarily involve a single currency. It is where member nations irrevocably fix their exchange rates to one another.
6. Complete Economic Integration – all of the above but also includes considerable political integration as well. Nations embark on harmonization of economic policies and there tends to be the development of a supranational state making decisions on behalf of member nation’s governments.
Economic integration has the potential to benefit all parties involved and create additional economic welfare. It also brings nations together politically and culturally which again, can be a positive.
Examples of Regional Trade Agreements (RTAs):
The number of RTAs has risen from around 70 in 1990 to over 300 today
The European Union (EU) – a customs union, a single market and now with a single currency
The European Free Trade Area (EFTA)
The North American Free Trade Agreement (NAFTA) – created in 1994
Mercosur – a customs union between Brazil, Argentina, Uruguay, Paraguay and Venezuela
Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA)
Common Market of Eastern and Southern Africa (COMESA)
South Asian Free Trade Area (SAFTA) created in January 2006 and containing countries such as India and Pakistan
New Zealand’s terms of trade rose by 2.5 percent in the June quarter, reaching a new record high.
Terms of Trade – Q2 2020
Export prices rose by 2.4 percent – forestry product prices rising by 11.1%, and dairy product prices by 4.1%.
Import prices fell by 0.1 percent in the quarter, driven by lower petroleum and petroleum product prices. This is despite higher prices for cellphones, televisions and laptops.
NZ’s high Terms of Trade highlights how NZ’s role as a food exporter will likely provide the NZ economy with some buffer as the global economy is rocked by the COVID-19 pandemic.
What is the Terms of Trade. The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another.
Formula: Terms of Trade (TOT) =
Export Price Index (Px) x 1000 (base year) Import Price Index (Pm)
An increase in the TOT (e.g. from 1050 to 1200) is called “favourable”
A decrease in the TOT (e.g. from 1050 to 970) is called “unfavourable”
A “favourable” (increase) in the TOT may come about because the average:
– export price rose and import price stayed the same – export prices rose faster than import prices – export prices stayed the same and import prices fell – export prices fell but import prices fell faster
The index number that results tells us whether merchandise export price movements have been favourable relative to import price movements. An increase in the terms of trade from 1000 to 1100 represents an increase in the purchasing power of our exports of 10% which means, other things being equal, we would be able to buy 10% more from overseas. As a country we would be wealthier. A decline in the terms of trade would result in the opposite situation.
Limitations of the Terms of Trade
Terms of trade calculations do not tell us about the volume of the countries’ exports, only relative changes between countries. To understand how a country’s social utility changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes in capital flows.
The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate one can expect the terms of trade to improve. However this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price. An example of this is the high export price suffered by New Zealand exporters since mid-2000 as a result of the historical mandate given to the Reserve Bank of New Zealand to control inflation.
In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.
A decline in the terms of trade is not necessarily a bad thing. For example, a decline in the terms of trade may occur due to a devaluation in the exchange rate. This devaluation may enable a country to regain competitiveness and increase the quantity of exports.
The impact of a decline in the terms of trade will depend on the elasticity of demand. If demand is elastic, the lower price of exports will cause a bigger % increase in demand.
Some Less Developed Countries (LDCs) have seen an improvement in terms of trade because of rising price of commodities and food post 2008. It is not always LDCs who see a decline in the terms of trade.
It is important to distinguish between a short term decline in terms of trade and a long term decline. A long term decline is more serious for reflecting a fall in living standards.
He discusses that the slowdown (Pre-Covid) is an indicator of economic prosperity. The economy has already provided much of what we need in life – comfort, security and luxury – that we have turned to new forms of production and consumption that enhance our well-being but do not contribute to growth in GDP. One chapter looks at the increase in imports from China and how it doesn’t necessarily have any connection with the level of GDP or growth rate. It is commonly portrayed in the media that imports from China have a negative effect on US GDP and you can say that they do impact on employment levels in certain sectors – e.g. manufacturing industry. This can lead to a slowdown in growth if workers didn’t find alternative employment. According to Vollrath the size of imports from China looks too small to account for the growth slowdown.
There is an assumption that imports lower GDP but most introductory economics courses refer to GDP with the following:
Y = C + I + G + (X-M)
Y = GDP, C = Consumption, I = Investment, G = Government spending, (X-M) = Exports – Imports With this equation if imports are higher, it must be that GDP is lower. The right hand side of the equation is just a way of accounting for GDP; it does not determine the size of GDP. Vollrath now puts imports on the other side of the equation so you have:
Y + M = C + I + G + X
The above equation helps given the common way that people understand the relationship if they imagine that M goes up, they’ll jump to the conclusion that one of the items on the right (C + I + G + X) must have gone up as well.
Y + M is the total goods and services available in a given year which we can purchase. The other side of the equation represents the purchasing of these goods and services whether it is consumption goods, capital good, government purchases and foreign purchases. An increase in imports means that there are more goods and services to purchase. But there is no necessary mechanical effect of having more imports on the size of our own production, GDP.
Teaching the ‘Trade’ topic with my NCEA Level 2 class and below is a very good graphic from the Statistics NZ site. New Zealand has recorded its fifth consecutive monthly trade surplus (June 2020) and the annual deficit for the year has fallen to its lowest in nearly 6 years – $1.2 billion. What has been noticeable since COVID-19 is that there has been buoyant demand for goods exports (particularly for food products), and weak domestic demand for imports. The surplus would have been $820m but for the one-off purchase of a naval ship – HMNZS Aotearoa. Interesting to note that exports to the US and EU are up whilst down for China, Japan and Australia. However both exports and imports are higher in monetary value ‘compared to June 2019. A lot to discuss in class from the graphic
Although in New Zealand the containment of the Covid-19 has so far been successful, with no international visitors the tourism sector has seen a sharp downturn. Those that have suffered most are the smaller operators and bars, restaurants, accommodation providers. Even with the wage subsidy a lot of these firms have been forced out of business. Domestic tourism will be essentially for the survival of a lot of the tourist spots around the country. The return of overseas visitors is some way off and even when restrictions are lifted visitor numbers are likely to be limited.
Visitor arrivals in New Zealand
Before Covid-19, Tourism was New Zealand’s largest export industry in terms of foreign exchange earnings. It directly employed 8.4 per cent of the New Zealand workforce. For the year ended March 2019:
the indirect value added of industries supporting tourism generated an additional $11.2 billion, or 4.0 percent of GDP.
tourism as whole generated a direct contribution to gross domestic product (GDP) of $16.2 billion, or 5.8 percent of GDP.
international tourism expenditure increased 5.2 percent ($843 million) to $17.2 billion, and contributed 20.4 percent to New Zealand’s total exports of goods and services.
As the economy struggles along people will be concerned about job security and look to be a lot more cautious with spending. However having been restricted during the lockdown there is the hope that New Zealanders will want to travel domestically.