Monday, September 14, 2015

Global Value Chains and Exchange Rates

From (excerpt):

The age of global value chains

João Amador, Filippo di Mauro 09 September 2015

There is an urgent need for policymakers to fully acknowledge the extent to which conventional indicators related to gross trade are severely flawed as policy benchmarks because they fail to take into account the existence of global value chains and their increasing role in shaping the global economy. This column, which introduces a new Vox eBook, urges academics to start proposing workable indicators that are systematically produced and readily available.

The importance of global value chains (GVCs) has been steadily increasing in the last decades and, as reported in UNCTAD’s World Investment Report 2013, about 60% of global trade consists of trade in intermediate goods and services, which are then incorporated at different stages of production (UNCTAD 2013). The prevalence of GVCs in the world economy impacts strongly on trade and labour markets, but also on issues such as inequality, poverty and the environment.

This notwithstanding, the measures that usually inform the policy debate, such as bilateral trade balances, export market shares or real exchange rates, continue to be used with little indication of the caveats that affect severely their accurateness.

In a recent VOX eBook we have collected relevant research by scholars directly or indirectly associated with CompNet, the Competitiveness Research Network of the EU System of Central Banks.

You can download the ebook here.

It’s not terribly clear what they’re really talking about, so here’s my notes from a recent presentation I gave:

  • Global production is fragmented
    • Finished products are made up of many components from many different countries
    • Each component is also the sum of parts from many different countries
  • An example
    • Company has (FX-denominated) imported inputs
    • Processing (domestic value-added)
    • Company has (FX denominated) exported outputs
  • Implications:
    • Impact of FX movements is ONLY on domestic value added
    • High domestic value-added = high impact and vice versa
    • Exports and imports move together
    • Export and import prices ALSO move together
  • Consequences
    • Devaluation/depreciation has smaller impact on competitiveness i.e. don’t expect an export boost
    • FX impact diminishes downstream but remains large upstream
  • Findings
    • Weaker currencies vis-à-vis USD protecting domestic margins
    • Weak commodity prices = weak import prices = weak export prices
    • Trade pricing suggestive of Sraffian/Post-Keynesian model, not Neo-classical
    • Nevertheless, indicative of lack of pricing power

Most commentators and policy makers still think in terms of gross trade values and finished goods. What I mean by that is, a depreciation helps boost exports because our export prices in foreign currency terms would be cheaper. Since demand curves slope downwards (volume demanded increases as prices decrease), we should see export volumes increase as the exchange rate depreciates (export prices might also rise at the same time). By the same token, a depreciation causes import prices to rise and import demand to drop. What that does to import volumes depends on the price elasticity of demand for imports – inelastic demand (say, energy related) would cause the overall import bill to rise, but elastic demand should see import volumes drop.

But the underlying implicit assumption here is that demand for both exports and imports are final (goods are assumed to be “finished” and consumed in the country of destination), and that these export goods have no imported components (100% domestic value-added). Even as early as the 1970s though (i.e. right at the beginning of the floating rate era), it was found that exchange rates did NOT pass through wholly into export and import prices. Exchange rate pass through has progressively decreased over the decades, as global trade boomed and production shifted based not on comparative advantage of the finished good, but based on comparative advantage of each stage of the production process.

For example, if domestic value added was just 20%, a 10% drop in the exchange rate would improve export competitiveness by just 2%. The full impact of exchange rate fluctuations would only be found in the countries of final destination, not in those countries within the (internationalised) production process.

That’s why countries experiencing large depreciations of their exchange rates in recent times, have only seen marginal improvement in export volumes (export receipts are another matter).

The bottom line here is that, with production of goods really fragmented across many different countries, the whole notion of “competitive devaluations” has lost much of its force. You can no longer really boost exports via exchange rate adjustments. By the same token, import price sensitivity to exchange rates have been equally muted (i.e. imported inflation is losing much of its power too).

The exception would be in countries at the beginning or end of the production process. Even here though, corporate pricing policies are increasingly geared towards a globalised market – the difference in prices of many consumer electronics items are virtually the same world-wide, once you account for differences in shipping costs and local taxes. There’s little opportunity for arbitrage.

It’s all about the value-added.


  1. "the whole notion of “competitive devaluations” has lost much of its force.". So can we safely say that china recent devaluation has less to do with boosting their export competitiveness?

  2. Hello Hisham,

    Insightful take, as usual. I am concerned anyhow, regarding the possibility of massive capital flights following investors and politicians' own anxiety of the current and future political climate, as illustrated in the past cases of Brazil, Philippines and Venezuela. Is there a chance of this thing happening to our economy?

  3. As I see it, everyone is at the mercy of the lawless big brothers. Their hot money wreak can havoc on any country's economic performance rather than just economic fundamentals. That's why no economist can ever reasonably predict economic boom and bust save for lucky coincidence.

  4. The exchange rate is just man made. So no one should be worried or try to over analyse as the europeans /us would like the rest of the world to fret about. As the Chinese have shown its all man made and they decide that a devaluation of the yuan is to their advantage. Now if every body realised this then where would the europeans./us be? haha..
    Devaluation is now a currency war. The lower the better haha... except to those who dont realised it.

    Just consider a 20% tariff on imported steel from China. The local producers wanted this as they know that will force local users to buy from them thus a 100% increase in sales and profit not 0.2%.

    They will then be rich and send their sons.daughters to the mat salleh countries they think they deserve. But a by devaluing the ringgit by 20% the same effect on sales is achieved. At the same time these newly rich will not be able to send their sons overseas but utilised underutilised colleges locally.
    Overthinking on finished and unfinished goods will be endless. Is oil palm a finish good. When ringgit goes down by 20% wont the Indian importers get 20% more oil palm? Volume will increase by 20% or more. This lead lower stocks and increase in prices.
    So a currency devaluation is a 100% positive for malaysia and letting others do it for us is better than manually doing it like China which the US term as manipulations haha..

  5. Ha..ha.. economic much ado over nothing.. it's the lawless rouge capitalists with their hot money that always prevail..

  6. Dear Hisham,

    I am referring to January 9, 2015 posting in Commodities and Currencies Part II. I am a student that currently exploring the application of VAR. In the article posted (last para), you narrated that given Brent is at USD50, the implied MYR/USD exchange rate should be 0.295. Basing on the results of the VAR, how did you come up with that??? Thanks Hisham

    1. @Rosnani

      Sorry for the late reply, I've been away.

      Once you have a more or less correctly specified VAR model, you can use it to forecast all the variables, both in sample or out of sample.

  7. Hohoho....I am back after a short hiatus...sacrifice,blood moon and all. And what a difference a mere two moons make.

    On August 13 I wrote this in one of the threads below:

    "By the way folks, cheer up. I get this nagging feeling that the Feds will ease off from jacking up them rates after all. Too much for them to lose especially their well connected firms, TPPA, anaemic growth and all...

    so they may opt to keep it going but it could be my wishful thinking anyway but there is that gut feeling so hope springs eternal. Who knows?the MYR will vault back to 3.50 this evening and from there the only way is up unlike snowflakes...hahahahahaha"

    Of course, the MYR hasn't vaulted back to 3.50 much less test 3.90 but soon it will, provided a certain fog clears locally (and thats a big "provided"....hahahaha). But leaving aside,our domestic mess, the USD is indeed tottering on the brink:

    And all the incoming data validates my contention that there has been effect no real growth due decelerated demand everywhere caused by virtually zero wage growth and QE's (or whatever permutation you call it) penchant for enriching the elite at the expense of the masses. And QE too has culled Mr Inflation for good so cue Central Bank panic everywhere QE abounds.....hahahahahaha .

    QE culled inflation? Ah..that's another story awaiting to be told, in the meanwhile I will further proof of QE failure in Japan in an upcoming sequel plus where did inflation go. And looming TPPA fiasco as well.....hahahaha.

    For the moment, as a reborn Hayekian(wink wink)...let me raise a glass of sake to the beginning of the end of New Keynesism aka Bernankeism + Krugmanism....hahahahahaha. This is sure fun!!

    Warrior 231

  8. Part 1

    Recent statements in support of the TPPA is perfectly understandable given the absence of similar multilateral free trade frameworks which can be used as predictive benchmarks. Nevertheless, a trade deal of smaller proportions that involves advanced economies and an emerging one does exist. It is called NAFTA and was initialled in 1994 between the USA, Canada and Mexico. So in a way NAFTA can be used as a bellwether of TPPA’s impact. And does it benefit Mexico, a sort of proxy for Malaysia, in the scheme of things?

    Initially until roughly 2002, there is some evidence of benefit to the Mexican economy:

    But over the long run, the negatives far outweigh the gains. Key points from the Executive Summary in pages 1 and 2 here include:

    1. Mexico ranks 18th of 20 Latin American countries in growth of real GDP per person, the most basic economic measure ofliving standards.

    2. From 1960-1980, Mexican real GDP per person almost doubled, growing by 98.7 percent. By comparison, in the past 20 years it has grown by just 18.6 percent.

    3. Mexico’s per capita GDP growth of just 18.6 percent over the past 20 years is about half of the rate of growth achieved by the rest of Latin America.

    4. According to Mexican national statistics, Mexico’s poverty rate of 52.3 percent in 2012 is almost identical to the poverty rate of 1994. As a result, there were 14.3 million more Mexicans living below the poverty line as of 2012 (the latest data available) than in 1994.
    5. Unemployment in Mexico is 5.0 percent today, as compared toan average of 3.1 percent for 1990-1994 and a low of 2.2 percent in 2000; these numbers seriously understate the true lack of jobs, but they show a significant deterioration in the labor market during the NAFTA years…..

    6. NAFTA also had a severe impact on agricultural employment, as U.S. subsidized corn and other products wiped out family farmers in Mexico. From 1991-2007, there were 4.9 million Mexican family farmers displaced; while seasonal labor in agro-export industries increased by about 3 million. This meant a net loss of 1.9 million jobs

    And the American Council of Foreign Relations (CFR) was not far off the mark in tarring NAFTA a failure vis-a-vis Mexico:

    “One lofty, unrealized promise of NAFTA was that the treaty would narrow the gap between the per capita incomes of Mexico, the United States, and Canada. Per capita income in Mexico rose at an annual average of 1.2 percent over the past two decades, from $6,932 in 1994 to $8,397 in 2012, far slower than Latin American countries such as Brazil, Chile, and Peru. NAFTA was also expected to discourage Mexican emigration to the United States, yet despite the 2007–2009 recession and increased deportations, Mexican-born people living in the United States doubled since 1994 to 12 million in 2013,….”

    Warrior 231

  9. Part 2

    One can deduce from the above that the US had gained more from NAFTA than Mexico and that’s par for the course when an advanced economy is matched against a developing one given a number of economic and non-economic factors.

    My take is that TPPA is designed to corner the emerging markets for US goods and services and in the long run would be deleterious to Malaysian economic growth. In fact, there is ample evidence to suggest that Mexico would be better off today had it opted for the pre 1994 status quo vis-à-vis Uncle Sam.

    Its all reassuring to say one can leave a trade bloc if things don’t work out but that would be too far down the road for any ill effects to be reversed, if ever. And leaving a trade bloc is synonymous with saying nyet to free trade.

    Hence my prognostication of TPPA of being potentially bad for Malaysia, especially to local industry and workers should be seen from an objective perspective.

    And given the torpor in global trade figures in recent times and stagnant global demand, I can't see how TPPA will mean access to bigger export marts hence higher earnings, job opps….blah blah.

    Forgive me for being a wet blanket but TPPA has all the hallmarks of a disaster in the making just like an ill timed GST (in fact I did suggest elsewhere in 2010 that it should be implemented in 2010 or 2011) or mistimed fuel subsidy withdrawal.

    And the negative ramifications of TPPA would extend far deeper and wider …wanna bet?

    Warrior 231

  10. Warrior 231

    How about posting whatever you want to say on your blog, rather than chipping in here to capitalise on the readership of Hisham's blog?

    If you know so much of the economy, why don't you establish your own readership economy in your own personal space? I've been waiting for hisham's reply to really understand the nature of things happening around our economy nowadays. He's a practicing economist, which makes his insights about the intricate interplay, or the limitation that exists either now or in the future valuable to people like me who are directly involved in trade activities.

    I'm reading to understand, whereas your reading is solely motivated by the desire to reply with something ambigously smart.

    I'm not - in any way - suggesting that your insights are inferior to hisham's. I'm merely stating that the manner in which you present them is somewhat distasteful.

  11. I think I am obliged to update you folks especially when I started with this in “Market Psychology”:

    So I thought it would be a good idea to bring everyone up to speed:

    I think in the end, whether we are pasar malam traders , corner shop operators or corporate high-fliers, we all need honesty to chart our business strategies and our lives. And of course, we must also understand that, likewise, the market places a premium on intangible currencies like trust, integrity and transparency when it makes its investment or divestment decisions. Yes, things that may seem inconsequential but are actually monumental as Brazil is finding out the hard way:

    “As the scandal spread, markets collapsed. The nation’s currency, the real, has plunged 32 percent this year, and stock declines have wiped out about $300 billion in market value. Initial public offerings have dried up, and mergers and acquisitions are at a decade low. Fitch Ratings on Thursday cut the nation to the cusp of junk, the fourth downgrade under Rousseff’s watch…….”

    The intricacies and complexities of economics are nice little things to look at and ponder about. But they mean zilch when hard earned (legally or illegally )dough is at stake and yes, the market does not give a damn to embroidery when personal wealth is at stake….

    For the life of me, even given my poor English and distasteful sense of humour, I cant yet figure what “readership economy” is all about and no….I am not being ambiguously smart about that!!Hahahahaha

    Had a good laugh to start off the week on Monday……a good laugh indeed!! ( still ROFLMAO...)

    Warrior 231

  12. Hello everybody! I am back! (Where's Hisham?) Lost all my hair but somehow just managing to go back to work. Anyway, thanks Warrior for your advice on currency last time round. Pound was at 2.22 then and if I had bought it would have cost me a couple of thousand dollars....

    1. Nice to welcome you back @The Slug. We may have our differences regarding issues but sure nice to hear that you are well and back at work. Take care and hope the haze is not bad over at your place.

      Warrior 231

    2. @The Slug

      Yes, welcome back, and I hope everything went well for you. I've been away myself, and come back with no hair either, though for much happier reasons. I was in Saudi Arabia for the past month on Hajj.

    3. The Slug,

      Great to hear from you and take care. My mum also had the C and she is now into juicing carrot. Apparently it well with the fight.

      Take care and God bless.

      Zuo De

    4. Apparently it help with the fight....

      Sorry type too fast.

  13. @Warrior 231 has made some excellent points. In particular his emphasis on "honesty" in all things.

    We might have avoided all the convolutions surrounding 1MDB, for instance, if it had been covered honestly, openly and transparently from the beginning.

    Coming back to the topic of global supply chains, it's not as if Malaysia can opt to quit the game and cut the links to these chains. Being a trade-dependent economy with a substantial manufacturing sector contribution to GDP precludes this, no matter how much the "nationalists" think the country can go it alone.

    There's a plethora of acronyms on the horizon - AEC, TPP, RCEP, OBOR etc. I don't know how many of them will actually see the light of day, but it behooves to be well-prepared when the day comes.