- -Real growth of exports to ernerglng markets (3 yr mov avg)

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1 Fro flywheel to fanbelt: the growing iportance of eerging arkets Eerging arkets are no longer acting as the flywheel on industrialized country growth. They are playing an increasingly powerful role in world trade, and their burgeoning deand has softened the ipact of the last recession in industrialized countries. Eerging arkets now account for a significant podion of US ultinationals' profitability. Street offers a growing "eerging arket" play. No longer a flywheel Eerging arkets have traditionally been regarded as a "flywheel on the G7 econoic engine" in other words, they are only able to grow when the industrialized countries are growing. The evidence shows that this view is no longer valid in recent years. In fact, during the last G7 recession, not only did eerging arket deand expand in absolute and relative ters but for the first tie it contributed significantly to keeping industrialized countries' export sectors alive. crises of and had a chilling ipact on deand in eerging arkets especially on those who were not coodity exposers. The period since 1990 shows an even harsher collapse in interindustrialized country trade, reflecting the deflationary shock of the assive expansion in cheap anufacturing capacity in eerging arkets. For the first tie in 30 years, real exports aong industrialized countries have fallen in absolute ters. However, exports to eerging arkets have shown rapid growth at the very oent that trade aong the industrialized countries has collapsed. Eerging arkets have helped to lead industrialized countries out of the last recession, and the disinflationary ipact of their copetitive anufacturing sectors ay well be acting as a "fanbelt" which restrains cyclical overheating tendencies in the G7. Leading the G7 out of recession? As Chart 4 on page 9 shows, over the last four years, halfofthe real increase in exports fro industrialized countries has been attributable to rising deand fro eerging arkets. Since the 1991 recession hit the industrialized countries, the ipact Chart 1 below tracks the real growth of exports fro of eerging IY~arket d~and has been even ore industrialized countries over the past 30 years. Until significant. Between 1991 and 1993, trade aong last year, there has been a very tight correlation industrialized countries declined by 8% in real ters. between the growth of trade aong industrialized However, their overall exports reained constant, countries and the growth of trade fro industrialized ainly because of burgeoning deand fro countries to those currently defined as "eerging eerging arkets. arkets." The two great inflationary shocks to trade (continued on page 8) aong industrialized countries related to the oil % 20.0 > 1: Export growth fro industrialized countries, oil") is appended at the R e a l growth of exports to industr~alized countries (3 yr ov avg) Real growth of exports to ernerglng arkets (3 yr ov avg) I I BBCA Publ~eataons LM 1994 I 6

2 The export sector in industrialized countries has iportant arket for industrialized countries' exports been growing in iportance in recent years. IMF since the late 1970s. Between 1976 and 1993, their data show the export sector's share growing fro an share of industrialized countries' exports has ore average of 7.9% of GDP for all industrialized than doubled fro 5.8% to 13.3%. For ost of that countries in to 9.7% of GDP in tie, they have been gaining at the expense of other (Needless to say, iports as a share of GDP have eerging arkets. However, since 1991, exports to also been growing during this period.) The other eerging arkets began to pick up. Chart 3 acceleration of exports fro indus below shows that in 1993 all regions trialized countries to eerging (even the oil exporters) accounted arkets has therefore coe at Exports to eerging for a growing share of industrialized precisely the tie when exports are arkets in 1993 were the countries' exports playing a ore significant role in of 22% of However, just as the recycling industrialized countries' GDP growth. industrialized countries ' ania of the 1970s peritted a teporary increase in purchasing GDP. Exports to eerging arkets in power in Latin Aerica, the current 1993 were the equivalent of 2.2% of booing deand for industrialized industrialized countries' GDP. Exports between countries' exports is being stiulated by anic industrialized countries declined by 8% in real ters capital flows to eerging arkets. Is this flow as between 1991 and 1993, while their overall exports fickle as that of twenty years ago? reained constant in real ters. Therefore, the The evidence suggests not. OPEC and Latin growth of their exports to the rest of the world (which Aerican iport deand in the 970s was related Chart 4 on page 9 shows is doinated by their alost exclusively to infrastructure and consuptionexports to eerging arkets) was the equivalent of related sectors, Iports by eerging arkets.rice 0.6% of industrialized countries' GDP. the id1980s have been doinated by capital A turning point goods destined to expand their export capacity. Although the overall share of industrialized countries' The corollary is that foreign direct investent (FDI) exports to eerging arkets is now not uch higher flows to eerging arkets have increased draatithan was the case in 1963, there appears to have cally, which iplies that a growing portion of the been a secular turning point in recent years. Asian profits accruing to ultinational corporations now developing countries have been an increasingly coe fro eerging arkets. 3: Industrialized countries' exports to eerging arkets (Share of total exports) t OBCA Publicadons Lld O Exports to Latin Aerica (left axis) U Exports to Eerging Europe (lefl axis) E x p o r t s to all eerging arkets (right axis) 8

$.... I..._ I.I.. '\.,:.. '.....'. *. #.$ 1994 1,000 0 1945 1950 1955 1960 1965 1970

3 BULLETIN 4: Exports fro industrialized countries, (7990 constant $) li Exports to other countries 0 Exports to eerging arkets H Exports to industrialized countries OBCA Publications LM : US corporate profit after taxes I..._ I.I.. '\.,:.. '.....'. *. #... Foreign Operations OBCA Publ~catlons ~td , Source: Citibase; Survey of Current Business 9

4 6: US ultinational corporations net profit argins by region 12 profit argins have diverged "Eerging Markets" o North Aerica, Western,,oa r OBCA Publ~cat~ons Ltd 1994 Europe and Japan '0 u0 Source: Survey of Current Business; EMA estiates for The ultinationals' profitability Over the past half century, USbased ultinational corporations (M NCs) have been drawing an increasing share of their net earnings fro affiliates outside of the United States. This ipact is evident in Chart 5 on page 9. Expressed in real ters, doestic earnings over the period have grown only arginally, rising at an average annual rate of about I %. Foreign profits, on the other hand, expanded alost ten ties as fast, growing at a brisk rate of 9.9% per annu. The consequence was that the share of net corporate profit coing fro foreign operations surged to over 25%, up fro only 7% in the late 1940s. This relative ascent was not linear, of course, with notable declines occurring in the early 1 960s, in the late 1970s, and ost recently during the late 1980s and the early 1990s. Downturns in this ratio were invariably associated with cyclical profit upswings in the US causing doestic earnings to rise faster than foreign ones. Since foreign profits continue to increase, their share in the total will likely resue its upward trend once the current US expansion starts running out of stea. Until the late 1970s, the shift 7: US ultinational corporations net profit fro "eerging arkets" affiliates as a share of worldwide total 81 I 6 1 I OBCA Publications Ltd in the share of profit coing I I I I I I I 1 I I I I 1 Source: Survey of Cunt Business; EMA estiates for

5 35,000 8: US foreign direct investent by region foreign direct investent heading into "eerging 5,000 /I Source: Survey of Current Business toward foreign profits was priarily the result of expansion by US MNCs into other industrialized countries, ainly in Western Europe and Canada. Since the early 1980s, however, the growth rate of profits fro affiliates in these countries started to decelerate and, fro the late 1980s onward, was surpassed by the uch faster rise in earnings coing fro eerging arkets. So far, the heightened significance of eerging arkets coes not fro a differential growth in their sales (which since 1982 reained rearkably stable at around 7.5% of the worldwide total for US MNCs), but rather fro rapidly expanding profit argins. Chart 6 on page 10 focuses specifically on US MNCs and shows the striking divergence in net profit argins (coputed as a ratio of net profit after taxes to sales revenues). The data here aggregate parent and affiliate operations in the industrialized countries (North Aerica, Western Europe and Japan), and contrast these with affiliate operations in eerging arkets. Since 1982, the cobined profit argin for the industrialized countries fluctuated ildly between 3.2% and 5.6%. Affiliates in eerging arkets, on the other hand, have seen their own argins rise fro 5% to over 9% in just a few years. The result of this divergence, charted in Chart 7 on page 10 was that the contribution of eergingarkets affiliates to total US MNCs profits has doubled, rising to an estiated 18% in 1994 fro only 9% in The reasons behind this developent are anifold. Partly, it is a consequence of cheaper labor and other direct costs in eerging arkets, but it also reflects lower taxation, lax governent regulations and environental standards, and in any cases also weaker copetitive pressures. These factors usually do not change very quickly. Profitability, however, is also subject to other considerations such as exchange rate and onetary policies, or political upheavals which in eerging arkets tend to be ore erratic and less predictable. The upshot is that although earnings fro eerging arkets are likely to continue and grow in significance, this growth will probably be ore volatile than the earlier expansion of affiliates in the industrialized countries. FDI With capital following the profit copass, it is hardly surprising that eerging arkets have taken the lead in attracting US foreign direct investent. Chart 8 above shows that while current US investent in Canada, Western Europe and Japan is not uch different fro what it was in 1985, direct capital inflows into eerging arkets have risen ore than six fold over the sae period. In 1992, US foreign direct investent in eerging arkets rose for the first tie to surpass siilar investent in the industrial countries, aking eerging arkets the largest current recipients of US productive finance. So far, the geographic distribution of profits was ainly affected by disproportionately higher profit argins in eerging arkets, but with capital spending now increasingly skewed in favor of eergingarkets their share in total MNCs sales is bound to rise, too. Thus, as long as 11

9: Japanese anufacturers currentprofitkales Doestic Operations a Foreign Affiliates 1985 1986 1987 Source: JETRO the profitargin differential does not fall, continued direct investent should push up

Japanese earnings still doestically driven Copared with their counterparts in the US, Japanese corporations are still in the early stage of their global expansion.

6 9: Japanese anufacturers currentprofitkales Doestic Operations a Foreign Affiliates Source: JETRO the profitargin differential does not fall, continued direct investent should push up sales by eergingarkets affiliates, aking the even ore iportant for their parents' botto line. Japanese earnings still doestically driven Copared with their counterparts in the US, Japanese corporations are still in the early stage of their global expansion. Despite recent hype around Japanese foreign investent, in 1992 Japanese anufacturing affiliates abroad accounted for a ere 6.2% of the total sales by Japanese anufacturers up fro 4.3% in US copanies achieved a siilar proportion by the late 1950s. Currently, Geran anufactures produce 20% of their output abroad, while US foreign subsidiaries account for 28%. Moreover, in contrast to the US case, Chart 9 above shows that Japanese foreign operations are less profitable than doestic ones (although the gap ust have narrowed during the recent Japanese recession). The reason ay be rooted, first, in the widespread use by Japanese copanies of "duping" and "predatory pricing" as a eans of penetrating new arkets abroad and, second, in protectionis and a tight oligopolistic structure at hoe. The sales and profitargin data suggest that only 3% of Japanese anufacturing profits coe fro foreign operations, which iplies that the share of eerging arkets proper is no ore than 12%. The strong Yen now exerts a relentless pressure on Japanese copanies to relocate production facilities BBCA Publications Ltd abroad, particularly to SouthEast Asia. However, this transition will take tie and its effect on overall corporate profits in Japan will likely be liited for the next few years, particularly if the doestic econoy recovers. Investent conclusions The rapid expansion of export anufacturing capacity in eerging arkets will continue to exert a disinflationary effect on industrialized countries. Eerging arkets could very well coe to be seen as the "fanbelt" which helps to cool off the inflationary consequences of rapid growth such as has been seen in the US this year. The high rates of return available on FDI flows into eerging arkets will continue to bid up the price of capital elsewhere, including eerging equity and bond arkets. The latter are reliant on foreign portfolio capital inflows and are therefore vulnerable to such global tightening. Investents in such US indices as the S&P 400 Industrials have a builtin "eerging arket play" of approxiately 20%. This iplies that the greater volatility of eerging arkets ay well begin to spill over into US stocks, which would therefore warrant higher risk preius and PIE ratios. Japanese stocks do not yet offer an eerging arkets play, except insofar as Japanese subsidiaries and affiliates are independently listed in eerging arkets.

7 / The ipact of oil Over the past 30 years, two huge shifts in world trade have taken place as a result of changes in oil prices. The current changes taking place as a result of the growing iportance of eerging arkets are fundaentally different. However, the history of the two oilrelated cycles helps to put present developents in context. Chart 2 below deonstrates the powerful ipact which oil prices have had on patterns of world trade in recent years. The 1960s had witnessed a rearkable expansion in world trade as a result of the Kennedy Round of tariff reductions. The principal beneficiaries of this trend were the industrialized countries, whose exports aong theselves expanded by an average of 10.7% per annu in real ters between 1963 and Consequently, their trade becae increasingly concentrated to reach a peak in 1970, when 76% of their exports were to each other. The rise in oil prices which began after the Tehran and Tripoli agreeents in 1970 and 1972 created significant export deand outside the industrialized countries. For the next decade, the oil exporters (including those developing countries which never joined OPEC) were a significant arket for industrialized countries' exports, accounting for an average 14.8% of their total exports between 1974 * % 2: Industrialized countries"export shares, and The collapse in oil prices during the id 1980s greatly diinished this export arket. A large part of the change in trade patterns during the 1970s and 1980s can therefore be attributed to shifts in the ters of trade. During ost of the period, the share of industrialized countries' exports going to eerging arkets has been in decline or has reained relatively constant, as indicated by Chart 2 below. The share of industrialized countries' exports to eerging arkets (excluding oil exporting developing countries) was in secular decline until the id1 970s. Two teporary factors resulted in eerging arkets' ability to iport ore fro industrialized countries after the first oil shock. The first was the policy of detente with the Soviet Union and China, which for the first tie since the second world war peritted substantial trade in such ites as Aerican wheat for Soviet gold, diaonds and oil. The second factor was the vogue for "recycling" oil revenue, whereby western coercial banks lent oney with no strings attached to developing countries. Latin Aerica's ability to iport fro industrialized countries was therefore teporarily increased until such tie as its debt servicing burden increased faster than its export capacity, which is what triggered the 1982 debt crisis. I / 8.0 / './* 6.0. Exports to o~l exporters and 'others'(left ax~~) 1. '. # I..,./, E x p o r t s to lndustr~allzed countries (right axls) OECA Pubfiwtlons Lld t W W C r D C ~ D b o b b b b b l S l o S O 3 r W l S U J E~~zz~~cn~""""zcD~ /' 7

Cyclical or Structural?

Cyclical or Structural? Global Trade Slowdown: Cclical or Structural? Cristina Constantinescu (IMF) Aadita Mattoo (B) Michele Ruta (IMF) Third IMF/B/TO Trade orshop 6 Noveber 2014 Main Messages orld trade grew less than 3 percent