Land of the not so free

Feature | 4 July 2016
US_Dollar

Clarissa Dann unpicks attitudes to current North American trade flows in the run-up to the US presidential election and queries how long the greenback will remain global trade's reserve currency

North America is, say some observers, on a trade brink as the momentum towards the US presidential election intensifies. Will Clinton or Trump follow through on the Trans-Pacific partnership (TPP)? Clinton seems to have had a change of heart. In 2012, she said, "This TPP sets the gold standard in trade agreements to open, free, transparent, fair trade, the kind of environment that has the rule of law and a level playing field."1

But in an interview on 8 May 2016, the position was rather different after a barrage of criticism for the trade deal on the campaign trail. "I said I would like to renegotiate NAFTA when I ran in 2008…and I currently oppose TPP in its current form."

Republican nominee Donald Trump is clearly no fan. "China is killing us, Mexico is killing us, Japan is killing us. Everybody is beating us. We have incompetent people negotiating trade," he said in June 2015,2 and if elected, he plans to impose a 45% tax on all Chinese imports and
a 35% tax on all goods imported from Mexico.

Cynics say that Clinton's stance was to secure the nomination and that it would actually suit her if the TPP bill did get through (there is not very much time after the summer recess) so that by the time she took office in January (if she does get in), she could distance herself from it as Obama's legacy, while actually letting it do its work. Trade supporters hardly dare contemplate a Trump victory, although Miller & Chevalier's trade expert, P Welles Orr , told TFR that he thought that whoever wins "will quickly stake out to whoever is the majority in the senate". If Trump got in, Orr predicts that he will take time out on trade (anything from six months to a year) to "revaluate" the TPP. "You would hope he would understand he cannot renegotiate a trade pact with 11 other countries," he comments.

Turning to Canada's new Trudeau government, Orr is rather more optimistic. "The government came into the picture with an open mind on getting the TPP done, although there was a concern it would take time out. However, the Canadians have had the challenge of completing the Comprehensive Economic and Trade Agreement (CETA),3 which now has problems on the European side - there are some real rumblings about what Canada gave up," he says.

Tripartite trade

The whole point of NAFTA is to facilitate trade growth between Canada, Mexico and the US. Since the agreement was ratified in 1994 to encourage trade among the three nations, it has morphed to become the largest trading bloc of its kind, encompassing more than 444 million people and US$17trn of goods and services. North American trade is the single most important trading relationship for each country. Between them, Canada and Mexico account for one-third of US exports and more than one-quarter of its imports.

Joon Kim, global trade product head for BNY Mellon's treasury services business, says that all three countries are feeling the effects of prevailing global trade headwinds, with global trade volumes and transactions down as a result of slowing global economic conditions and the slowdown's effect on commodity prices and other economic factors. "The three-country trading sphere faces some trade challenges that are particular to the region. Trade levels are highly concentrated along corridors connecting the three countries, and this concentration may create too much regional dependency within the Americas, especially if trade continues to show more robust growth levels within Asia - let's not forget the fact that 10% of traditional trade transactions are now settled in RMB - and along south to south corridors."

The relevance and importance of agreements such as NAFTA is underlined by trade disputes that are resolved by arbitration. When commodities giant Cargill reached a NAFTA arbitration settlement with Mexico for US$77m, on grounds that Mexican tariffs on their high fructose corn syrup were illegal - its Mexican factories were an investment under the terms of NAFTA Chapter 11 - this was a reminder of why NAFTA was needed in the first place. Until its arrival, many high tariffs remained in trade between North America and its southern 'back yard' neighbours.4

America's largest trading partner is Canada, with whom it shares what is dubbed the "longest undefended land border in the world". Active promotion of trading links and investment with Canada led to agreements such as those relating to motor vehicles in the 1960s. These fueled a significant increase in US vehicle sales in Canada in exchange for large investments in motor vehicle parts manufacture in Southern Ontario. Trade between the countries was however made more costly by American insistence on cabotage relating to the transport of goods, viewed by some as an additional form of protectionism. This all goes back to the Merchant Marine Act of 1920, requiring all goods transported by water between US ports are carried on US flag ships constructed in the US, owned by US citizens, crewed by US citizens and US permanent residents.

"It is reasonable to assume that the new trade agreements will spur US export demand, as should some of the increasing flows in new markets we are seeing in Latin and South America," says Chris Bozek, managing director, head of North America trade and supply chain finance, and global trade product head. He says existing agreements have, on average, tended to raise incomes across the board and improved trade flows. "Beyond NAFTA we support multilateral trade agreements as they open up markets, reduce barriers to entry, provide long-term benefits, and are a net positive for the
global economy."

But, he counters, while free trade agreements can have considerable benefits for parties on both sides, there are other considerations. "Corporates and banks need to look at the value of foreign exchange rates and their inherent volatility. Other considerations are the levels on non-tariff restrictions, sovereign debt, economic stability, and foreign direct investment. All are pieces of the puzzle that impact trade flows beyond trade agreements," says Bozek.

The other point in all of this is that such agreements are not all entirely balanced. The World Bank and IMF are very western leaning OECD-focussed organisations. The Chinese are trying to put together a competing trade agreement. As one banker who did not want to be identified quipped, "It's the second largest economy in the world - while they have hit a bit of road bump, they clearly want to take their place in the global economy. So they are starting their own party."

Uncle Sam is not in the best of health, and, as Hogan Lovells' US-based partner Aaron Cutler observes, the mood is generally one where people feel, for the first time, that their children will not necessarily have a better life than they had and that the middle class is shrinking. "Trade is usually the way out of this, but people are arguing that NAFTA has hurt US jobs," he told TFR, citing the emergence of automobile plants in Mexico as allegedly having damaged America's automobile industry. Bankers say that the never-ending appreciation of the US dollar, coupled with reduced overseas market demand, is making exports "more difficult".

Export finance

The long-dated export credit agency business did reasonably well for the main export finance banks, but the market still shrank by 30% last year. "We are not seeing a lot of companies making major investments right now," said one export finance provider. His bank partners with ECAs all around the world but can no longer count on the US Ex-Im bank, now that its reauthorisation has left it without much of a board and the ability to do any transactions in excess of US$10m. "For our business, most of our transactions are hundreds of millions of dollars. For us, Ex-Im is still closed," said the banker.

Cutler, whose article 'Quorum leap - what happens now the US Ex-Im Bank is back in business'5 is not confident of the bank's long-term survival. "I think it will probably get killed at some point and it will be death by a thousand cuts, shutting down for six months and returning with a more narrow scope and smaller budget." The bank's contribution to the economy and US jobs is overshadowed, said one banker who did not want to be named, by the "high degree of politics involved", compared with its Canadian counterpart, Export Development Canada. However, EDC is more detached from government control than US Ex-Im. "Unlike most export credit agencies that rely on governmental annual appropriations, we are financially self-sufficient and operate much like a commercial institution. We collect interest on our loans and premiums on our insurance products. We also have a treasury department that sells bonds and raises money in global capital markets," it states.

Bank of America Merrill Lynch is, says Bozek, "one of the leaders in the Ex-Im working capital programme targeted at the SME market". He firmly believes that ECAs help level the playing field for smaller SMEs, making it possible to compete against larger, better capitalised companies.

How green is the greenback?

While the US economy might be recovering from its 2013 fiscal cliff wobbles, total federal government debt of US$19trn is still a rather large number, which, when examined alongside the fact it has a trade deficit with the rest of the world, is almost US$2bn every day.6 While America has been posting large trade deficits (April 2016 stands at US$34bn), the Chinese have been racking up the surpluses (US$230bn from 2005 to 2015)7.

This does raise questions about the status of the dollar as the world's reserve currency. Some argue that debt is only an issue if you cannot repay it or people think you cannot repay it, but for how long can the US print increasing amounts of dollars on the assumption there will always be a demand for them on the basis of their interconvertability with oil?

Examination of the holdings of US dollar bonds shows that the major holders are Europe, Japan, China and the Middle East. However the present situation is such that with practically zero interest rates, it means that a huge proportion of the existing bonds are in fact now offering negative yields, such that the amount of principal left owing will be less than originally lent. If found in circumstances where it was actually costing you money to lend it to someone, then common sense would dictate that one would seek to transfer the non-performing asset into something else, or even seek to cut your losses and invest any retrieved money into property or a reliable hedge against inflation, such as gold.

So it is seems hardly a coincidence that the Chinese have been diminishing their holdings
of foreign currencies and buying large amounts
of gold.
 

In the June 2016 edition of Gold Investor8, former UK central bank governor Mervyn King observes, "Over the last decade or so, the claims by some emerging market countries on the US have grown. Who knows what the future holds, but China and other countries do not want to be in a situation where all their international assets are in effect dependent on the US. Of course, the US would not want to renege on its debts, but if some awful conflagration occurred, then all China's assets in the US might be annulled. So there are plenty of big concerns that make it extremely reasonable to have assets in your portfolio that are not dependent on the goodwill of other countries."

So, it does seem that a reasonable assessment of the risks associated with US based trade must at least allow for the possibility of a substantial, and possibly very quick, devaluation of the dollar, coupled with a significant fall in demand from abroad for both dollars and treasuring bonds, plus global moves away from reliance on oil for dollars."

Despite the growing prominence of the renminbi in global trade, the dollar's position as a reserve currency does not look set to budge - just yet. Marvin Loh, global market strategist at BNY Mellon comments, "We've seen predictions over the past decade that the role of the US dollar as the world's reserve currency would be curtailed. The development of the euro as a currency
for an economy the size of the eurozone was one of the first salvos in the search for another currency with a profile similar to the US$ on a global scale. Then came the economic rise of China: more widespread use of its currency was - some would say, still is - expected to provide
yet another alternative to the dollar.
More recently, the weakness in commodity prices and oil prices over the past several years have most certainly curtailed the amount of petrol dollars available for global investment."

 

He confirms, "Despite all the predictions and expectations related to these developments, the role of the US$ as the reserve currency seems to be mostly intact. For instance, the value of indirect participants in the treasury auction process can be viewed as a proxy of foreign interest in US government bonds. These levels are generally at their highest levels ever, with indirect bids accounting for more than 70% of recent ten-year auctions. Additionally, there has not been a noticeable shift in US$ holdings on the part of reserve fund managers; the percentage of these holdings in US$ has been above 60% since the financial crisis."

Given the launch of the gold-backed yuan in April 20169 and that China no longer exports gold, might suggest that the mighty dollar's reserve currency status is not as unassailable as it once was.
 

Clarissa Dann is the editor-in-chief of TFR.
She is grateful to silver trader and blogger
Simon Littlewood for his research
 

Box-out 1

United States

Key Industries

Nearly all industries are represented in the US. The following ones are key.

Agriculture

Although this sector accounts for just 1% of the region's total GDP (US$17.938bn), the US is one of the world's most important agricultural producers, particularly of grain.

Automotive

The US automotive industry is the largest in the world and includes the two largest vehicle manufacturers, General Motors (GM) and Ford. American car companies have large benefit commitments to their employees and have seen their market share challenged by Asian competitors.

Weak consumer demand and preferences for more fuel-efficient vehicles with smaller profit margins battered the industry during the global financial crisis, but the sector recovered from 2012. Machinery and transport equipment accounted for 9.58% of exports in 2013. Sales rose 5% annually in April 2015, continuing an upward trend establishing during the preceding year.

Financial services

Financial services accounted for 7.9% of GDP in 2012 (latest available information), but this understates its importance in the economy. The US has the largest equity markets, insurance market and banking sector in the world.

Energy

The US is the world's largest single energy market, representing some 25% of global consumption of oil, natural gas, coal and nuclear energy, with 84% of energy consumption sourced domestically. It is the second largest producer of coal and has the fourth largest reserves of the mineral, which provides approximately half of its electricity generation needs. Consolidation in the coal sub-sector is expected as natural gas supplies increase.

In early 2012 the government announced that it would sell leases on 38 million acres in the Gulf of Mexico for offshore exploration. The area was estimated to contain up to a billion barrels of oil and four trillion cubic feet of natural gas.

Nuclear energy is another significant component of the energy market. The US produces nearly a third of the global supply of nuclear electricity and accounts for over 19% of total production. Between 2007 and 2013 applications for 24 new reactors were made, scheduled to come online beginning in 2020. These could be delayed, however, by the discovery of vast natural gas reserves.

Shale oil exploration and extraction is growing, centred in the north-east of the country and in the state of North Dakota. Exploration may be hampered by lower oil prices from mid-2014, however.

In July 2014 the US Department of Commerce predicted that the US would become the world's largest oil producer in 2015, and produce all of its energy domestically within the next two decades.

 

Box-out 2

Canada

The following is a summary of Canada's key industries by territory.

Alberta

Alberta has one of the most generous allotments of energy reserves in an energy-rich country. Other industries include gas, coal, manufacturing of iron and steel products, agriculture, livestock, lumber, tourism and food processing.

British Columbia

The main industries are services, lumber and related industries, food processing, mining and manufacturing (particularly electronic items). This is a prime fishing area. Outdoor recreation and tourism bolster the local economy.

Manitoba

Agriculture, especially cereals, plays an important role, but industrial production is increasing in significance, particularly printing, chemicals, metals and machinery. There are rich mineral deposits and abundant timber.

New Brunswick

About 85% of the province is forested; lumber and lumber products play a significant role in the economy, along with tourism, which is encouraged by the province's natural parks. Manufacturing and a fledging communications industry contribute to the local market.

Newfoundland and Labrador

The fishing sector and the processing of related products have declined. There is mining in Labrador but, because of the unfavourable climate and poor soil, food has to be imported. The property and energy industries are likely to expand given increased demand and new offshore projects.

Nova Scotia

Coal mining, fishing, fruit and vegetables are the main industries. Tourism, especially for sporting activities, is also important.

Ontario

Toronto is the main centre for the service industries, insurance and banking. Manufacturing and industrial products also contribute to the provincial economy. Agriculture and livestock are developed throughout the province, together with mining in the north and fruit production in the south, where there is a developing wine industry. There are also hydroelectric facilities in the south (Niagara) and tourism throughout the province.

Prince Edward Island

Tourism, fishing and agriculture are the main pillars of the economy, with notable products including shellfish, livestock, fruit, vegetables and potatoes. Tourism is encouraged by devotees of the books by L M Montgomery, which are set on the island. Manufacturing is mainly restricted to food processing.

Quebec

Second after Ontario in industrial production, Quebec has vast resources of hydroelectric power in the north. Science, technology and communications have recently emerged as growing sectors of the economy. Agriculture and farming are carried out in the lowlands and there are mineral deposits including iron, copper, zinc, gold and silver. Tourism is also important.

Saskatchewan

The province is mainly important for farming of both cattle and cereals. In addition there are rich deposits of minerals, oil and natural gas. Industrial processing of raw materials and timber production are also significant.

The Territories: Northwest Territory, Yukon and Nunavut

The economies of the Northwest Territory and Nunavut are centred on mining, fishing and trapping. Oil is refined on the Mackenzie River and there are mineral deposits. In the Yukon mining remains the leading industry, principally copper, lead, zinc, silver and gold.

Box-out 3

Mexico

Key Industries

Agriculture

Agriculture accounted for 3.12% of GDP in 2013 and 13.39% of employment in the third quarter of 2015. The principal products are maize, beans, rice, fruit and oilseed.

Despite being an important contributor to jobs, agriculture is inefficient and has failed to keep up with the growth in population. Mexico is now a net importer of foodstuffs and must import maize, the staple of the Mexican diet. Mexico imports more than 40% of its food needs from the US.

Manufacturing

Mexico's economy has shifted from its original emphasis on oil, mining and agriculture to a semi-industrialised model. The liberalisation of the economy has aided the process, encouraging greater foreign investment. Manufacturing represented 16.06% of employment in the third quarter of 2015. The sector accounted for 16.95% of GDP in 2013 and 84.82% of exports in 2014.

Mexican manufacturing has seen successes in iron, steel and machinery production as well as in the food and beverage, chemical, textiles and paper sectors. Subsidiaries of many of the world's leading car manufacturers, attracted by Mexico's cheap production costs and proximity to the US market, also use Mexican factories.

A prominent feature of the Mexican manufacturing sector is the "maquiladora" system, which is inbound assembly for re-export. Products such as vehicles, electrical goods, textiles and furniture are manufactured in some 3,500 maquiladora plants near the US border. The industry employs more than one million workers, representing Taiwanese as well as US companies.

Mexico is re-emerging as a manufacturing hub for US businesses, given its relative geographic proximity and competitive wages, which are lower than those for Chinese workers. Mexico is also increasingly viewed as an affordable source of skilled labour and has attracted a number of international car makers. Honda opened an auto plant in February 2014: the complex was expected to manufacture the Fit subcompact vehicle

in Celaya.

In 2014 Mazda also announced the opening of a car plant valued at USD 650mn in Salamanca. The plant was expected to produce the Mazda2 and Mazda3 models. Nissan and Audi were also planning to expand operations in the country, confirming Mexico as a leading manufacturer for the industry. Luxury operations are expanding, with BMW disclosing plans for a plant project valued at USD 1bn in July 2014L the plant was expected to begin operations in 2019. Mexican-made models are forecast to account for 25% of cars sold in the US by 2020. The internal market is also growing, partially offsetting the temporary drop in exports expected over 2015 and 2016.

Minerals

Mexico is the world's second largest producer of silver and a major producer of other minerals such as fluorite, arsenic, strontium, graphite, copper, iron ore, sulphur, mercury and zinc. There are also gold deposits. Precious metals make up over 35% of non-oil mineral output. It is estimated that 60% of Mexico's land mass has mineral production potential of which 25% is known and just 5% has been explored in detail. Minerals constitute Mexico's fourth largest source of foreign currency. Rare earth extraction is seen as a future growth area.

Oil and gas

Mexico is the seventh largest oil producer in the world. Energy supplies over a third of government revenue and oil represents 10.79% of all exports. Mexico had proven reserves valued at 10.26bn barrels in 2014. Production decreased from 3.5mn barrels per day (bpd) in 2007 to a forecast 2.25mn in 2016.

The energy sector is controlled by the state-owned monopoly PEMEX, which was set up in 1938 when foreign-owned oil companies were nationalised. PEMEX is developing some 29 fields spread over 2,400 miles (3,862 km) north-east of the capital. The project, known as Chicontepec, provides 30,000 bpd and is projected to produce 700,000 bpd by 2017. PEMEX believes that the area could hold hydrocarbon reserves equivalent to 17.7bn barrels of oil.

PEMEX is understood to be investing more in improving recovery rates from its mature fields and to be moving towards drilling in much deeper waters in the Gulf of Mexico. Two new offshore fields, Tsimin-Xux and Ayatsil-Tekel, were expected to produce a combined 270,000 bpd from 2016. Higher recovery rates were expected to bolster daily output by 600,000 bpd within the current government term.

Mexico's shale reserves are estimated to be among the 10 largest in the world. The government estimates its total reserves, including unconfirmed deposits, could equal 45bn barrels of oil and 500trn cubic ft (14.16trn cu m) of natural gas.

Nevertheless Mexico has only confirmed 17.22trn cu ft (487.62bn cu m) in gas reserves. Under-investment in the state-run sector has led to a decline in production, converting the country into a net gas importer. Prior to recent liberalisation the government attempted to circumvent constitutional restrictions on private investment by introducing multiple service contracts (MSCs) that allow companies to perform a wide variety of services. This allowed PEMEX to increase gas production without breaching the prohibition on non-state operators holding exploration and production concessions.

Following years of under-investment foreign companies are needed to support additional exploration and investment. President Nieto has endorsed partial privatisation along the model provided by Brazil's Petroleo Brasileiro SA (Petrobras) to bring in more investment. This objective was supported in December 2013 by the passage of a bill approving private production and profit-sharing contracts and exploration licences, followed by three block auctions in 2015. The auctions showed progressively greater interest in response to government concessions; the first, in July, saw only two of 14 blocks sold; however, the auctions in September and December were more encouraging. Investors purchased three of five production-sharing contracts in September, and all of the 25 contracts offered in December that year. The latter auction enabled domestic companies to operate oil fields independently, in line with recent liberalisation. The public remains opposed to outright privatisation of the national oil company.

Tourism

Tourism is the third largest source of income after oil and remittances. It is a lucrative industry that provides direct and indirect employment in Mexico's extensive services sector. Tourism was estimated to support 4.29 million jobs directly and account for 5.9% of GDP in 2014. Major companies include Aeromexico, Grupo Posadas and Sol Melia. Mexico has a number of luxury enclaves, including Cozumel, that are beyond the budget of most Mexicans, who find it cheaper to go to Miami. Approximately 80% of tourists to Mexico are from the US despite concerns regarding gang violence.


Remittances

Remittances sent home by Mexicans working abroad, mainly in the US, constitute another major source of revenue. In 2014 Mexico was the recipient of the fifth largest volume of remittances in the world, representing USD 24.23bn. Remittances are expected to fall in the longer term as the Mexican economy grows and employs more resident

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