Lesson 4: Foreign Trade, Exchange Rates, and Competitiveness

Lesson 4: Foreign Trade, Exchange Rates, and Competitiveness 1. Stylized Facts of Spanish Foreign Trade 1.1 Geographic Distribution 1.2 Foreign Trade Evolution 2. Exchange Rates 2.1 Interest Rate Parity Condition 2.2 Evolution of the Euro exchange rate 3. Competitiveness 3.1 Competitiveness Indicators 3.2 Sectoral Specialization

1 Stylized Facts of Spanish Foreign Trade 1.1 Geographic Distribution of Spanish Foreign Trade Foreign Trade: Main Aggregates 200000 180000 160000 mill euros 140000 120000 100000 80000 60000 40000 20000 0 1971 1973 1975 1977 1979 1981 1983 1985 1987 Exports Exports-EU Imports Imports-EU 1989 1991 1993 1995 1997 1999 2001 2003

Distribution of Exports by area of destination 1973 1980 1985 1990 1995 1999 2003 OECD 70,2 64,4 70,2 82,6 82,5 83,5 83,5 EU12 41,1 44,2 44,3 58,7 61,0 61,3 60,1 EU15 (non-euro) 6,9 7,4 7,4 9,8 10,2 10,3 11,0 Rest of Europe 5,5 5,2 5,4 2,0 3,1 4,4 5,9 Latin America 7,0 8,5 5,1 3,4 5,6 6,2 4,7 USA 13,9 5,3 9,9 5,8 4,1 4,4 4,1 China 1,0 0,4 0,8 Japan 1,0 1,4 1,3 1,1 1,4 1,1 0,8 Rest of the World 24,6 28,0 26,6 19,1 14,5 12,4 13,5 Total 100,0 100,0 100,0 100,0 100,0 100,0 100,0

Main Features 1. Europe has always been the main destination of Spanish exports. Most exports go to the euro area. After entry in the EU, this trend has increased. In the last years, Eastern Europe has emerged as a new destination (and Spain is a net exporter to the area). 2. Nevertheless, Latin America during the 1970s and also at the end of the period in the 1990s has more weight in the Spanish exports than what would be expected from the importance of the Latin American economy. 3. The importance of the US economy as a destination of Spanish exports has declined from over 10% to less than half that number. 4. Japan s share is stable and very small, taking into account the importance of Japan in the world economy. The share of exports to China is not increasing, in spite of the rise of the Chinese economy.

Distributions of Imports by area of origin 1973 1980 1985 1990 1995 1999 2003 OECD 70,4 52,3 66,8 78,7 81,2 81,9 77,8 EU12 36,6 26,6 31,2 50,1 55,7 57,5 55,7 EU15 (non-euro) 6,6 4,8 5,6 9,0 10,0 10,2 8,7 OPEC 11,8 27,6 10,1 7,4 5,5 5,1 6,3 Rest of Europe 2,6 2,3 2,4 2,1 2,6 2,4 4,4 Latin America 7,3 8,5 10,6 4,2 4,2 3,9 4,0 USA 16,1 13,1 10,9 8,4 5,4 5,4 3,6 China 2,0 2,7 3,6 Japan 2,5 3,4 4,4 3,3 3,2 2,6 Rest of the World 19,0 14,6 25,8 14,4 11,3 9,6 11,0 Total 100,0 100,0 100,0 100,0 100,0 100,0 100,0

Main Features THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID 1. Europe has always been the main origin of Spanish imports. Most of them come from the euro area. This trend, again, was reinforced by entry in the EU. In the last years, Eastern Europe has emerged as a new source of imports. 2. The OPEC countries are consistently among the three largest exporters to Spain. 3. The share of Latin American goods over total imports decreases in the 1980s and never recovers. 4. There is a secular decline in the importance of US products. In 1973, the US was the second main origin of Spanish imports with more than 16% of Spanish imports. The figure now is lower than 4%. 5. Japan s share is stable around 3%. China s share is increasing and now the value of imports from China equals that of the US.

1.2 Foreign Trade Evolution Intra-EU trade (% over total) Imports Exports 1986 1996 1986 1996 Austria 69,5 76,5 64,1 72,3 Belgium-Lux. 73,4 72,5 78,1 76,6 Denmark 49,8 70,1 62,2 66,7 Finland 47,4 65,3 50,5 54,6 France 67,6 67,6 57,1 62,2 Germany 58,1 59,0 60,2 56,4 Greece 62,2 62,5 68,6 49,8 Ireland 75,9 66,1 73,9 70,6 Italy 59,9 60,9 55,2 55,2 Netherlands 64,7 61,2 81,3 80,6 Portugal 62,8 75,6 75,5 80,0 Spain 54,4 67,9 63,7 66,8 Sweden 72,3 68,2 57,4 57,2 UK 55,3 54,9 52,2 58,3 EU 61,8 63,3 62,2 63,0 Source: Martín (1997)

Main Features: THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID Intra-EU trade flows are the most important trade flows for all EU15 member countries in both periods (only exception is Greece s exports). Increase in intra-eu flows at aggregate level. For some countries, intra- EU imports decreased (UK, Sw, N). For some, intra-eu exports decreased (Ger, N, Gr). For Spain, intra-eu flows have increased (in 1996, around 2/3 of X and M) (Not shown) Main EU export markets for Spain: France (28.5%), Germany (20.4%), Italy, Portugal, and UK (12% each). (Not shown) Main EU import origins: France (27%), Germany (23%), Italy and UK (13% each). Spain as an important partner: Portugal (M:30%, X:19%) and France.

Revealed Comparative Advantage Index and Grubel and Lloyd Index: The index of revealed comparative advantage is the trade balance within each industry i: scaled by the total balance in the industry: RCA i = X X i i + M M i i x100 Industries with revealed comparative advantage have values closer to 100. Industries with no comparative advantage have values closer to 100. The Grubel and Lloyd Index measure for any industry the level of intraindustry trade (0<B i <100: nothing/everything is intraindustry trade): B i Xi Mi = 1 x100 Xi + Mi

Intra-industry trade may result from: vertical product differentiation (distinct countries/industries produce different qualities) or from horizontal product differentiation (distinct countries/industries produce different varieties, e.g. distinct preferences for characteristics that are not ranked) Unfortunately, there does not exist direct quality indices. Proxies must be used instead. 1. The Unit Value Index is the ratio between the value and the volume of exports (imports): UVI X i = N j = 1 P N j = 1 X ij Q iq X ij X ij

It is thus possible to compute the ratio between the IVUs of exports and imports. A threshold, close to unity, is defined (e.g. 15%). Exports varieties are of lower quality as compared to imports if: UVI UVI X i M i < 1 0.15 There is horizontal differentiation if: X UVIi 1 0.15 1+ 0.15 M UVI Exports varieties are of higher quality as compared to imports if: i UVI UVI X i M i > 1+ 0.15

Revealed Comparative Advantage Indices in Manufacturing EU Rest of the World 1986 1996 1986 1996 High technology -38,2-30,6-36,4-19,5 Electrical equipment -30,4-24,6-49,1-15,1 Data Processing -35,3-37,8-77,9-56,9 Chemicals -44,1-32,9-7,5-1,4 Medium technology 0,8 1,9 21,8 12,4 Plastics -1,7-8,4 38 4,2 Transport equipment 18,8 13,6 28,9 24,0 Machinery -34,4-33,2 16,2 10,2 Other manufacturing 17,3 3,8 3,7-17,9 Low Technology -1,6-3 19,3-0,6 Textiles 27,9 5,2 28,7-6,9 Iron -21,4-16 21,8-10,7 Other mining 6,6 26,6 32,7 47,0 Paper -16,6-23,3 34,7 24,0 Food and Tobacco 11,4 2,8-5,1-22,1 Metals -15,9-10,4 43,0 39,7 Total -10,4-7,8 3,1-2,1 Source: Martín (1997)

Main Features THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID Both with respect to the EU and to the rest of the world, Spain does not have comparative advantage in sectors with high technological content Comparative advantage with respect to the EU is concentrated in sector which are intensive in blue collar labour (textiles) and physical capital (transport equipment, natural resources) Comparative advantage with respect to the rest of the world is mainly in natural resources, transport equipment, iron products, and paper derivatives.

Growth of intra-industry trade in sectors with initial revealed comparative advantage (transport equipment, textiles, and food processing): Índexes of Intra-Industry Trade UE Resto del Mundo 1986 1996 1986 1996 High technology Electrical equipment 54,0 53,8 30,7 55,5 Data Processing 63,7 42,7 23,0 36,3 Chemicals 42,6 52,1 37,5 43,0 Medium technology Rubber & Plastics 54,2 70,8 28,4 51,2 Transport equipment 57,3 66,5 38,9 53,3 Machinery 53,4 54,7 54,2 45,7 Other manufacturing 39,3 55,7 27,6 32,7 Low Technology Textiles 34,6 56,1 26,4 35,6 Iron 67,5 72,6 37,0 44,0 Other mining 44,6 50,8 11,9 27,2 Paper 60,2 52,1 23,4 26,5 Food and Tobacco 23,9 39,5 20,9 26,4 Metals 34,8 52,2 14,4 19,9 Total Manufacturas 48,7 57,8 28,2 39,9 Fuente: Martín (1997)

Characteristics of intra-industry trade 1996 EU Rest of the World Vertical Horiz. Total Vertical Horiz. Total High Low High Low Electrical equipment 17,8 20,2 15,8 53,8 15,1 22,8 17,6 55,5 Data Processing 18 7,2 17,5 42,7 23,9 8,9 3,5 36,3 Chemicals 10,1 31,1 10,7 52,1 11,8 22,5 8,7 43 Plastics 10,4 12,7 47,7 70,8 12 10,2 29 51,2 Transport equipment 6,8 49 10,7 66,5 9,4 15 28,9 53,3 Machinery 15,2 24,4 15,1 54,7 7,8 30,9 7 45,7 Other manufacturing 26,5 17,8 11,4 55,7 24,4 2,9 5,4 32,7 Textiles 17,3 12 26,8 56,1 24,5 2,6 8,5 35,6 Iron 23,8 34,5 14,3 72,6 29,3 9,7 5 44 Other mining 14,9 23,4 12,5 50,8 7,8 16,9 2,5 27,2 Paper 6 27,1 19 52,1 4,5 18,2 3,9 26,5 Food and Tobacco 9,1 13,6 16,8 39,5 13,9 4,9 7,6 26,4 Metals 4 18,4 29,8 52,2 8,5 5,5 5,9 19,9 Total 11,5 29,2 17,1 57,8 14,4 13,6 11,9 39,9 Source: Martín (1997)

Characteristics of intra-industry trade: evolution 1986:1996 EU Rest of the World Vertical Horiz. Total Vertical Horiz. Total High Low High Low Electrical equipment -8,6-0,7 9,1-0,2 2,4 9 13,4 24,8 Data Processing -23,2 1,7 0,5-21 18 1,1-5,8 13,3 Chemicals -5,2 10,3 4,2 9,5-4,1 5,2 4,4 5,5 Plastics 3,2-29,6 43 16,6 2,3-9,2 22,3 22,8 Transport equipment 1,5 2,3 5,4 9,2-11,2 8,7 16,9 14,4 Machinery 8,8-14,5 15,1 1,3-3,6-7,9 3-8,5 Other manufacturing 18,8-7,3 4,9 16,4 15,9-15 4,1 5,1 Textiles 7,2-7,8 22,1 21,5 9,6-3,7 3,3 9,2 Iron 8,9-3,8 0 5,1 13,6-6,3-0,2 7 Other mining 8,7-4,1 1,6 6,2 5,1 8,5 1,7 15,3 Paper -4,6 0,3-3,8-8,1 1,6 10,3-8,7 3,1 Food and Tobacco 1,3 2,8 11,5 15,6 2,2-0,5 3,8 5,5 Metals 0,7 4,7 12 17,4 5,2 0 0,3 5,5 Total 0 1 8,1 9,1 3,7 1,6 6,4 11,7 Source: Martín (1997)

Main Features THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID Vertical intra-industry trade (15% difference in unit value indices) is predominant in most industries. Quality of exports to the EU is smaller than quality of imports from EU in vertical intra-industry trade. Until 1992, growth in intra-industry trade was taking place mainly because of vertical intra-industry trade (not shown). After 1992, growth in intra-industry trade of goods of the same quality (unit value index) has been more important than exchange of goods of different quality.

2 Exchange Rates THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID Why?

2.1 Interest Rate Parity Condition THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID The exchange rate between the Euro ( ) and the Dollar ($) is determined by actions of those agents who sell and buy in the currency markets in order to carry out international payments with these currencies. Participants in the currency markets: exporters and importers of goods and services, banks, bureaus de change, tourists, and speculators Financial institutions such as commercial banks are by far the most important participants, both in terms of their numbers and the volume of their operations. How are exchange rates determined in the currency markets? As in most markets, by the interaction of supply and demand.

Foreign currencies are risky financial assets: the profitability in euros of a bank deposit denominated in dollars will depend both on the interest rate of the deposit account and the evolution of the exchange rate between the dollar and the euro. Define: E $ : euros per dollar R $: annual interest rate of deposit in dollar account E e $ : expected euro/dollar exchange rate after a year TR $ is the expected amount of euros at the end of the year minus the initial euro: TR $ = (1+R $ ) E e $/E $ - 1 = (1+R $ ) (E e $ - E $ )/E $ A simplified version of this formula ignores second order terms and reduces to the following approximation: TR $ R $ + (E e $ - E $ )/E $

Interest Parity Condition: TR = TR $ : Currency markets can only be at equilibrium when all deposits, regardless of their currency denominations, yield the same expected profitability (What happens if the euro-deposits have larger profitability than the dollar deposits, R > TR $?) Expected profitability of dollar accounts is inversely related to the current exchange rate euro/dollar: the larger the number of euros needed to buy a dollar, the lower the profitability of the investment. On the other hand, the expected profitability curve of euro-denominated deposits does not depend on current exchange rates. The parity condition determines E $ as the equilibrium exchange rate.

Current exchange rate THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID Profitability in eurodenominated deposits: TR Profitability in dollardenominated deposits:: TR $ E $ Profitability

What happens if R increases? The curve TR shifts to the right and E $ moves down: making euro-denominated deposits more attractive leads to an appreciation of the euro (?E $ ). What happens if R $ increases? The curve TR $ shifts to the right and E $ goes up: when dollar-denominated deposits are more attractive the dollar appreciates (?E $ ). Finally, what happens if there is an increased expectation of depreciation of the euro in the future (?E e $)? The curve TR $ moves to the right:?tr $ R $ + (?E e $ - E $ )/E $ At equilibrium, E $ goes up: an expected future worsening of the exchange rate leads to a worsening of the current exchange rate.

This basic model of exchange rate determination can be easily enlarged by introducing shares and portfolio investment decisions: Portfolio investments in euro shares will increase if expected firm profits in the euro area improve. Portfolio investments in dollar shares will increase when expected profits in the US economy increase. To sum up, the euro/dollar exchange rate is affected by current interest rates, expected future exchange rates and growth expectations in the two economies.

2.2 The euro/dollar exchange rate since January 1999: Swift decline until October 2000 of approximately 40% against the dollar (but also against the yen and the pound) Faster US growth: Throughout 1998 pre-euro currencies experienced an appreciation against the dollar that was attributed to the then larger expected growth potential in Europe. As it turned out, average growth in the US was (much) faster than in Europe in the following two years. Positive interest rates differentials between the dollar-deposits and the euro-deposits. Capital outflows from the euro countries to the US (partly offsets the traditional asymmetry between direct and portfolio US investments in Europe against European investments in the US)

Appreciation since the end of 2001 (also against the yen and the pound) Positive interest rates differentials between the euro-deposits and the dollar-deposits. European capital withdrawals from the US and also an increase in the international use of the euro by third countries Are these movements in the exchange rates exceptional from a historical perspective? We can obtain a large historical series from 1974 to 2000 by merging the actual euro series from 1999 with the pre-euro synthetic euro: 1. The highest value of the synthetic euro/dollar exchange rate took place in 1985. 2. The appreciation trend of the dollar that ended in 1985 started in 1979 and lasted 21 quarters. The last appreciation trend has been shorter in time as it begun in 1996 (16 quarters until the third quarter of 2000).

3 Competitiveness THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID What is the competitiveness of an economy? Difficult question, with many candidate answers. One is The sustained capacity to maintain or increase its presence on World markets. This definition encompasses two definitions of competitiveness: 1.- External competitiveness : analysis of comparative advantage 2.- Global or structural competitiveness: ability to achieve sustainable improvements in relative standards of living (i.e., compared to other countries).

Thus, we have two alternatives to analyse competitiveness : External competitiveness Global or Structural competitiveness Result indicators (ex-post) Current account (affected by cyclical fluctuations) Export shares Import penetration Per capita GDP and productivity Determinants (ex-ante) Nominal exchange rate Cost, relative prices and relative profitability Factor endowments Innovation potential Productive specialisation Corporate organisation and market efficiency

3.1 Competitiveness indicators THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID The trade balance is open to criticism, as it is influenced by cyclical fluctuations: 20000 6 15000 5 10000 4 5000 3 0-5000 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2 1-10000 0-15000 -1-20000 -2 X-M GDP Growth

However, it does reflect an increasing imbalance in external trade in the recent past As an alternative, we can normalise by the activity of the country that consumes these tradable goods: Export share of goods from A on B = Import Penetration Rates for A = M PIB A X A B M B A

Main features: THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID Import penetration has approximately doubled over the 10 years. The share of World exports reaches a maximum of 2% in 2001. It has fallen slightly since then. In terms of its ability to deliver sustained improvements in standards of living as compared to other countries, the Spanish economy.

has experienced positive relative growth which has led to a reduction of the wedge in per capita income.. However, this relative income per capita growth has coincided with a reduction in apparent labour productivity and total factor productivity (not shown). In order to understand the loss of competitiveness, it is useful to compute the Real Effective Exchange Rate. The latter picks up variations in nominal exchange rates as well as inflation differentials. In addition, the ratio between the export deflator and the unit labour cost index is known as the Relative Profitability of Exports.

Computing the Real Effective Exchange Rate: Price index of Spanish tradable goods expressed in euros: P Price index of Rest of the World tradable goods expressed in dollars: P* Euro exchange rate with respect to the dollar (euros per dollar): e Þ Dollar price of goods produced in Spain: P/e The ratio 1 e ( ) P P* expresses the dollar price of goods produced in Spain relative to the dollar price of goods produced in the Rest of the World (an increase reflects a relative increase in the dollar price of goods produced in Spain).

With t = 0 as base year, we obtain an index of the Real Effective Exchange Rate: 1 P t * P e t t P t e 100 100 0 P REER x x 0 t = = * 1 P e 0 t P t e * * 0 P0 P 0 The percentage variation decomposes into: REER P P * t t t e = t REERt Pt P * e t t

That is, the relative price of Spanish goods with respect to the Rest of the World increases if: Spanish prices increase: P t > P t 0 Prices in the Rest of the World fall: P * t P * t < 0 The euro appreciates with respect to the dollar (the nominal component) e t > 0 e t

Evolution of the REERs and index of the relative profitability of exports 93-98 average 99-04 average Relative profitability of exports 0,9-0,8 With respect to developed countries Manufacturing industrial prices -2,4 1,0 Unit Labour costs -3,0 1,7 Nominal Component -3,9 0,1 With respect to Newly Industrialised Countries Manufacturing industrial prices -0,9 1,6 Nominal Component 0,5 1,1 Source: Servicio de Estudios del Banco de España (An increase reflects a relative increase in the price of Spanish goods)

Main features: THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID There is an increase in competitiveness until the fixing of euro parities. A deterioration thereafter. The improvements in competitiveness of the first period are particularly marked with respect to developed countries. The main reason is the peseta exchange rate (nominal component) After euro entry, the nominal component negatively affects competitiveness (with respect to Newly Industrialised Countries). However, at the beginning of the 2000 s, the level of prices and costs were lower in Spain as compared to EU-15 and higher than the enlargement countries (not shown).

Structural Determinants of Competitiveness 1993 2004 Spain/UE15 Spain /US Spain /UE15 Spain /US Capital/Labour (%) 89,4 95,5 91,2 90,9 (R+D)/GDP (%) 45,8 35,2 55,0 40,7 No. of patent requests by million inhabitants (%) 11,5 11,0 16,1 16,5 Years of schooling (%) 97,5 87,5 95,6 100,0 Source: Servicio de Estudios del Banco de España Main features: Marked reduction in the capital intensity wedge with respect to the EU. Nonetheless, there remains a large gap with respect to technological capital

3.2 Sectorial specialisation: competitiveness in the tourist sector 11% of GDP, 10% of employment (largest national productive sector). Spain is the second country in terms of international tourist demand. The tourism surplus, that stands above 4% of GDP, covers, on average, 80% of the deficit in the trade in goods balance. At the beginning of the 2000 s, the number of visitors has been equal to the resident population (but average spending has fallen).

Determinants of tourism competitiveness: THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID REERs in the tourism sector are characterised by a marked appreciation since 1999. However, the level of relative prices of the Spanish economy with respect to the EU-15 average in 2000 were similar to those of 1995. The competitive position is weaker with respect to Eastern European countries of the Mediterranean. In the last years, profitability indicators have been moderate. They are below those achieved in France and Italy.

With respect to the structural characteristics: High geographical concentration in terms of the origin of the foreign visitors. High concentration in terms of destination. High seasonality. Few foreign visitors motivated by work and business (a higher daily spending is associated with this kind of tourism). Sector dominated by Small and Medium Sized firms.

(a) % of Spanish tourism revenue in the World total THE SPANISH ECONOMY UNIVERSIDAD CARLOS III MADRID

(b) Increases are associated with losses of competitiveness

Main features: Clear positive tendency during the entire period in terms of market share. As of 1998, tourism revenues have not increased as fast as the trade in goods deficit. During the last years, there has been a loss of competitiveness with respect to the competitor countries (Fr, Gr, It, Pt, Austria, Mex) as well as with respect to the origin (client) countries (EU, US, Switzerland, Can, Mex, Jap.).