China Research

The Baltics in Search for Exports

June 3, 2015

In 2014, Estonia grew by 2.1%, Latvia by 2.4%, and Lithuania by 2.9%. Flash estimates for Q1 2015 report GDP growth dipping to 1.2% YoY in Estonia and Lithuania (contraction of 0.3% and 0.6% QoQ), and 2.0% in Latvia (still up 0.4% QoQ). Investment activity has been quite weak for a couple of years whereas consumption growth has remained by and large robust. Thus, the key reason for the dip in growth seems to be external, i.e.: (i) collapse in Russian demand, and (ii) subpar EU growth.

If subpar EU growth has tamed the upside for the Baltics (overall it still holds good growth prospects as the EU demand is still rising), Russian contraction and especially the rouble depreciation have an outright negative hit. The reason for Russia’s contraction is its chronic structural weaknesses (excessive dependence on oil, poor rule of law, weakness of market institutions) – reinforced by sanctions (impaired access to finance and technologies due to the sanctions from the West, but also Russia’s own imposed embargo on food imports) due to the Russia-Ukraine conflict.

Flash estimate for Q1 2015 reports Russian GDP to have shrunk by 1.9% YoY. Real household incomes are down about 10% YoY as are retail sales; investment activity seems to have fallen through the floor. It could have been worse… with oil prices gradually picking up, the rouble has stabilized at somewhat stronger levels than expected, which means that inflation, though still at about 16%, seems to have peaked and is likely to start retreating. Industrial output has reported small positive numbers. Still, Russia is set to shrink further this year and recession is likely to end only in 2016. Moreover, when recession will end, recovery will be bleak low single digits as its old oil-driven growth model has run out of steam and there is nothing broad and strong enough to substitute for it. So, there is not much hope for strong demand growth from Russia over the longer term either, even when ignoring the lagging rule of law, investor protection and geopolitical risks.

How does this Russia trouble affect the Baltic economies? It has cut sharply into the Baltic exports – in Q1 2015, goods exports to Russia fell by 29% for Latvia, 34% for Lithuania (-60% for Lithuanian origin goods) and 49% for Estonia from one year ago. More difficult to measure, but confidence must also have suffered, reducing investment activity. Yet, the overall impact is not that devastating at all. Despite the massive drop of exports to Russia, total exports have grown a tad for Latvia (up 0.4% YoY), and only marginally inched down for Estonia (-0.4%) and Lithuania (-3.8%; -4% for Lithuanian origin goods). Thus, the good news is that the massive fall in the exports to Russia have been compensated with expansion in other (mainly EU) markets. So far we see only limited and contained impact – within certain sectors or companies – on corporate profitability and liquidity.

In short, the Baltics are coping quite well with this. One of the reasons is that it is not the first time the Baltics see something like that; during the 1998 Russian crisis, for example, dependence on trade with Russia was much larger than it was before the current watershed, so companies have been diversifying their markets for a long time. As to the sanctions – Russia has had a habit of introducing one off sanctions against specific goods already before and also quite regularly (e.g. there was a ban specifically on Lithuanian milk products in 2013). Companies know how to react in such instances. Yes, this is costly, but companies have seen it before and know what to do.

We expect the Baltic goods exports to Russia to fall by 30%-50% in 2015, and trade links with Russia to weaken substantially. Russia’s share in goods exports has been shrinking, e.g. for Latvia, from 9.4% in Q1 2013 to 6.8% in Q1 2015. To compensate for the shortfall in Russia, there has been a spectacular growth to many so far for quite exotic markets for the Baltic exporters such as Middle East, China or Japan. But the major volume growth has been already established to the core partners of the EU. The share of destination EU has risen, e.g. for Latvia from 70.9% in Q1 2013 to 75.4% in Q1 2015, and it is likely to continue going forward. If political alliances for the Baltics have clearly been with Europe, fast and lucrative export growth to Russia and its peripheral trade partners at times may have put politicians in a situation to weigh among political and economic alliances… now political and economic alliances are likely to become closer aligned, which will add to stability – and this is good.

We see the dip in early 2015 as temporary since a gradual pick up in EU growth (supported by ECB quantitative easing stimulus) must lift European demand and thus the Baltic exports and consumer spending. Overall, we expect the Baltics to grow by about 2% in 2015 and 3% in 2016. Slower than before, but not that bad either.

Mārtiņš Kazāks
Swedbank Deputy Group Chief Economist and Chief Economist for Swedbank in Latvia

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Should the Yuan Become Part of SDR?

Chinese statements and domestic debate make increasingly clear that China soon wants to become part of the International Monetary Fund’s (IMF’s) artificial currency, the so-called Special Drawing Rights (SDRs) – also described as kind of reserve currency for the IMF-member countries. Currently, one SDR contains fixed amounts of four currencies denominated in USD, i.e. somewhat above 40 percent for the USD and slightly below 40 percent for the EUR plus around 10 percent for both the GBP and the JPY.

In January 2016, the Chinese want their renminbi (RMB) to become the fifth currency in the SDR basket. The question, however, is whether China already is mature for such a big step. To get there, some main criteria for SDR entry have to be met:

– the size of the country’s exports;

– the currencies included in SDRs should be “widely used” and “widely traded”

The first criterion, of course, would be easily met by China, the no 1 exporting country in the world.

The evaluation of the second criterion with its two parts, however, is much more complicated. One must certainly note the RMB today is widely – and increasingly – used when it comes to international trade finance. Chinese RMB or yuan have also a growing weight in the composition of currency reserves in an increasing number of central banks.

Consequently, the possible membership of the RMB in the SDR composition will probably be decided by the interpretation of the question whether the Chinese currency is “widely traded” – which in my view should be related to free forex trading of all over the world. This is currently not the case. The IMF is talking more precisely about “widely traded in the principal exchange markets” which, however, opens for broad interpretations. As the IMF expressed the issue very recently: the future inclusion of the RMB in the SDR is not a matter of “if” – but of “when”.

Altogether, I feel strongly that joining the SDR by the RMB already in January 2016 would be premature. I share the view that China will be there at some point in the future. Reforms of the domestic financial system and the gradual deregulation of the capital balance seem to be much more important than the RMB’s joining of the SDR already in a couple of months – and not to forget the need of much better transparency. But we know that the Executive Board has the mandate to change the entry criteria, by, for example, giving emerging markets more influence in IMF decisions.

Hopefully, the decision by the Executive Board of the IMF will be based purely on economic, financial and institutional criteria – and not on political considerations. Nota bene: This is no opinion against emerging markets per se which I indeed have sympathized with since many years ago.

Sources: http://www.imf.org/external/np/pp/eng/2011/092311.pdf http://www.imf.org/external/np/exr/facts/sdr.htm

Hubert Fromlet
Senior Professor of International Economics, Linnaeus University
Editorial board

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The AIIB and How Not To Repeat Historical Mistakes

May 6, 2015

Old hero looks on bad temperedly as would-be new hero launches his idea for a new global financial order. Old hero tries for all he is worth to prevent the new idea from gaining currency among his erstwhile followers. His efforts are to no avail. The new hero manages to amass overwhelming support for his proposed institution.

Ah you might well say. This is all about the Asian Infrastructure Investment Bank, new hero being China and old hero being the USA. Right? Yes indeed. But there is actually another answer which could be considered equally as correct. It is the case of the creation of the IMF. On that occasion the new hero was the US with the UK being the grudging old hero. At that point, not even an alternative idea put forward by none other than John Maynard Keynes was able to prevent the dollar based international structure from being born.

The IMF was created in 1945. And now it is 2015. 70 years is a long time in economics, perhaps. Yet surely not that long for the American memory not to be stirred and to recognise the irony of the turn of events. Well may be not. But it is certainly an indication that people react in pretty much the same fashion when the same kind of shock hits them.

That said it is difficult to envisage the renminbi acquiring the position that the US dollar did in the immediate postwar years. In passing, it should also be noted that the US dollar’s reign itself did not last that very long. The dollar’s convertibility to gold was terminated in 1971 after all, thereby effectively ending the dollar’s position as unchallenged international key currency. Nevertheless the Chinese currency is even more disadvantaged than the dollar of those days in that China’s economic supremacy of today is nowhere near that of the US in the immediate postwar years. At that point, everyone else was struggling with postwar redevelopment. They desperately needed dollars to finance that endeavour. The renminbi is so clearly not in that position.

In Japan we have the saying “acorns comparing heights” indicating competition among contestants who are not that different from each other in terms of ability. There is no outstanding winner with undisputed might. This is very much the case now that we live in a highly globalised world in which people, goods and money flow so effortlessly over borders. No single nation or region can boast of being the oak tree rather than an acorn. China may be an extremely super large acorn but it remains an acorn nonetheless and not the tree.

Moreover, the dollar of pre-1971 years was the only currency that was convertible to gold at a fixed price. The renminbi enjoys no such exceptionality.

All this being said, one can understand China’s motivations behind the AIIB initiative quite well. It needs access to the infrastructure development market of Asia. In needs some big projects on which it can use up its vast excess production capacity. Having run out of investment opportunities inside its own economy, it is now looking for space elsewhere. It is also looking for a way out of dollar-dependency. It wants access to global finance in its own right without having to rely on the dollar as a gateway.

So the new kid on the block is trying to grow up in a workable fashion. The US should look back on its experience of 70 years ago and try to avoid the British mistake of attempting to block the newcomer’s way. Begrudging new people access to club membership is never a very sophisticated thing to do. They will sulk, become defiant and go on to create a club of their own. This will more often than not lead to unproductive squabbles and pitch warfare.

It was refreshing to watch the British manoeuvre on this occasion. To be the first to stand up and be counted as a member of the AIIB club was a stroke of piratical genius. It seems that the country’s buccaneer spirits have not died down completely. A completely different performance to 70 years ago. Much more sensible. It is a typical case in point which shows you that when you are no longer the old hero whose position is being threatened by youthful rivals you can relax and come up with some impish ideas about position taking.

Most pitiful in this context has been Japan’s response to the AIIB idea. It would have done better to try to outdo the British. If a young and upcoming very large Asian acorn is trying to boost infrastructure development in the area, a more mature and more experienced Asian acorn of not at all negligible size should welcome the opportunity to lend a hand. Or even both hands. Having secured the position of wise old advisor, Japan could have gone on to mediate between old hero and new hero. Alas no such luck. Japan just keeps looking on with scared stiff eyes for the new comer and apologetic diffidence for the old timer. Pathetic.