Protection - An Umbrella For Investments In Reckless Market

PROTECTION

It is only natural that democratically elected governments should yield to populist protectionism at the slightest risk, real or imagined, of rising unemployment. This has happened time and again in the past. The current global economic slowdown has yet again given rise to a debate on whether developed economies will go down that path, and some observers expect the worst. A more nuanced assessment of today’s financial and economic world persuades us that save a few pockets, any large-scale protectionism is not feasible, never mind the din of political rhetoric. Today’s global economy is much more functionally and financially integrated than it was a few decades ago. Ownership of businesses and assets is dispersed across borders: production is domiciled in countries that make it cost-competitive and efficient (frequently, far away from center’s of consumption); and capital is truly fungible, chasing the best risk-adjusted returns. Global trade has increased the productivity of all participants, be they developed countries or developing ones. Thus it is no surprise that exports’ share of world GDP has more than tripled, from ~9% in the 1960s to ~32% today. Over 1992-2007, cross-border capital flows have galloped, with FX contracts alone quadrupling. Emerging markets have benefited from surging growth on the back of a 20-fold jump in private capital flows (to a meaningful US$500bn) in the past three decades—and many large developed economies are in no small measure dependent on savings of less-developed countries. The world is too interdependent for any large-scale attempts at protectionism to endure. The political class will always have the temptation to reanimate the protectionism bogey, though economic compulsions will circumscribe such attempts. One thorny issue is export of jobs through outsourcing or allowing foreigners into the job market through issuance of work permits (such as H1B visas in the US). Policy responses to such issues will continue to be dictated by political expediencies. Barriers to influx of skilled labour will rise, as illustrated by the recent condition contemplated by the UK government to restrict it to those with master’s degrees. Such measures pose a serious threat to the Indian IT industry, which is among the largest users of visas for skilled workers. Similarly, sectors like steel or auto manufacturing, which employ large labour forces, could see trade barriers getting erected. However, such moves will necessarily be limited by availability of local capacities; take for instance textiles, in which the US is so dependent on imports that it can make barely one-third of its needs domestically, even at full capacity utilization. Outside services (especially ITrelated), metals and auto manufacturing, we see limited risk of any of the larger economies adopting a protectionist stance. Is financial protectionism, such as restrictions on export of domestic savings, a greater risk? The Institute of International Finance estimates private capital flows to emerging markets will decline to US$165bn in 2009, almost 80% lower than the near-US$1 trillion of flows recorded in 2007. While it would be simplistic to blame the shrinkage solely on protectionism (there were far larger factors at play, such as deleveraging and falling risk appetite), there is no denying that there is great political pressure on banks to accelerate credit disbursals to kick-start domestic growth. Countries with high current account deficits and external debt will likely remain under pressure, as external capital is unlikely to flow back in a hurry. Some of the world’s largest banks have received sovereign assistance and will thus be subject to the diktats of the lawmakers, which are not always driven by pure economic reason. The impact of any protectionist stance will be very different on India and China. India’s trade balance is still negative, so the world needs India as much as India needs the world (to export to). The potential

impact on China, a far bigger exporter, would be far greater—though few developed economies would venture to upset the apple cart, given their dependence on Chinese savings to finance their ballooning federal and corporate debts. Furthermore, nearly 58% of China’s exports are from foreign invested enterprises, rendering any protectionist stance an even more complicated issue. What is certain, though, is that a slowdown in FDI will hurt both, as it has been a substantial driver of growth in capital formation in the past. In sum, we believe the fear of protectionism is overdone; no large economy can afford to erect barriers to trade or capital, as the costs and pain from such a stance are too onerous to bear. The political leaders of the largest economies realize this and the recent G20 meeting in London—though it was more symbolic than substantive—corroborates this. A few pockets of protectionism are unlikely to have any meaningful impact on the world economy, though some industries and countries will be affected more than others. World trade has come so far in the last century that it is nearly impossible for a consumer in any developed country to buy completely indigenous products at a reasonable cost. By the same token, developing countries would be hard-pressed for high-tech research and innovation, were it not for trade relations with developed countries. Trade makes the world highly integrated A sustained rise in trade flows has made the world a far more integrated place than it was a few decades ago. World trade’s share of GDP has risen from less than 10% in 1960 to over 30% in 2007. Private capital flows increased 20x between 1980 and 2005. External debt of low- and middle-income countries rose from ~50% of GDP in 1980 to ~80% of GDP in 2005. The composition of world trade has also changed substantially, having shifted from primary commodities (food, fuels, minerals, etc) to higher-value articles such as manufactured products. More importantly, trade in manufactured products has been driven primarily by vertical specialization, wherein a country imports raw materials (primary commodities) from the cheapest source, manufactures the finished goods at a relatively inexpensive price, and exports them to an altogether new destination. For example, India imports fabric from China, textiles accessories (buttons, threads) from Sri Lanka and manufactures fashion garments, which it then exports to Europe. Both developing and developed countries have gained In addition to the increase in quantity and nature of trade, international trade has also become more inclusive. Share of middle-income countries in international trade has doubled, from 11% in 1960 to ~24% in 2005. Developments in technology have made transfer of know-how from developed to emerging economies easier, thus allowing developed countries to benefit from lower manufacturing costs.

Share of middle-income countries in world trade has doubled in 45 years.

Notably, growth in exports from Asian countries has surged, thanks to their cost advantage in manufacturing and assembling (autos, technology equipments, textiles) and access to raw materials (chemicals iron and steel). Asia’s growth mainly driven by cost advantage in manufacturing

For the developed world, this growth in trade has translated to an unprecedented, multi-decade uptrend in productivity. The US, for instance, has seen an acceleration in labour productivity growth from an annualized rate of 1.2% in the 1970s to reach ~2.5% in the present decade. Gain in labour productivity stems mainly from two factors: competition effect (cheaper imports drive an increase in domestic productivity, to enable domestic producers to compete with imports); and re-allocation effects (resources are reallocated from less productive to more productive firms). The reallocation effect also means a shift of resources to higher-value efforts, which in turn increases the average compensation of labour (as the labour pool’s composition shifts from blue-collar tasks to higherend manufacturing/services industries). For instance, in the US, compensation in pharmaceutical (R&D) and high-end personal-care services grew faster than that in textiles and footwear manufacturing (as these goods have increasingly been sourced from abroad).

Multifold rise in capital flows means rising financial integration

In addition to trade, cross-border capital activity has also gained pace. Private capital flows to emerging countries have increased almost 20 xs in less than three decades, from less than US$30bn in 1980 to ~US$500bn in 2008. Cross-border flow of capital has been particularly strong over the past decade and a half, with volumes of foreign-currency contracts up ~ 4 xs between 1992 and 2007. Volumes in other asset classes such as equity derivatives have also risen sharply, by 4 xs in 11 years. Private capital flows to emerging countries up >15x in <30 years With capital flow restrictions across borders easing over the past decade, corporations have also increasingly resorted to tapping foreign sources of capital. The number of foreign companies listed on major international exchanges—NYSE, London Stock Exchange (LSE) and Singapore National Exchange (SNX)—has risen 2-10x since the beginning of this decade. Also, cross-border borrowings have risen sharply amongst low-income and middle-income countries. External debt of middle-income countries rose from 23% of GDP in 1970 to 50% in 2005, while that of low-income countries rose from 18% in 1970 to 79% in 2005. Developed markets have also benefited from capital inflow Just as emerging markets gained from capital inflow (much of which was invested in equities), so have developed countries such as the US (as a result of trade surpluses in export-oriented Asian countries). In the US, capital inflows were invested largely in government treasuries, though a small part also found its way to equities. Foreign holdings in US treasuries up 12 xs in seven years Flat world rules out large-scale protectionism. With more than 30m jobs lost worldwide, USA’s unemployment rate at 8.5%—a 10-year high—and global market capitalization down US$30trn, the time is ripe for knee-jerk populism. On the other hand, the world is intricately integrated today, rendering any serious attempts at pan-industry protectionism probably unviable and almost certainly futile. Deteriorating macro indicators normally precede protectionism Macro parameters affecting the masses are increasingly grim. One key indicator is the unemployment rate, which reached 8.5% in March 2009 in the US and 8.5% in February 2009 in the Euro zone. Not surprisingly, labour-intensive industries are the most strident when it comes to lobbying for protectionist measures. A case in point is the Big Three automakers’ and steel companies’ ever more frequent representations to the US Treasury. Furthermore, these industries are big contributors to America’s tax revenue, and this makes them particularly influential. Manufacturing, for instance, accounts for about 12% of the employment in the US and 22% of the government’s tax revenue (see chart below). This gives it immense clout in dictating tariff and non-tariff protectionist measures.

Flashback: The Great Depression (1929-33)

The Great Depression, which started in the US, ended up affecting almost every major economy of the times. Global trade collapsed, with exports declining 60% in nominal terms and over 35% in volume terms from their peak. Much of this is blamed on the Smoot Hawley Act, passed in 1930—soon after the stock market crash of 1929. However, opinion remains divided on whether the passing of the Smoot Hawley Act was in response to the recession, or merely happened to coincide with it. That said, we think it would be inappropriate to lay the blame for the collapse in global trade squarely on the protectionist policies during the Great Depression. Firstly, contrary to popular perception, the Smoot-Hawley Act was not a protectionist measure in response to the Great Depression, but almost entirely driven by internal US politics. Preparation for the bill started in late 1928, well before the Great Depression. The Act was finally passed in June 1930—a good 18 months after the bill was tabled. The Republican Party (which had protectionist leanings back then) sought to bring back the high tariffs that had existed when it last held the presidency, and which the Democrats had brought down earlier. When the SH bill was finally voted on, 92% of house Republicans voted in favour of it, while 91% of Democrats opposed it; in the Senate, 78% of Republicans voted in favour of it, while 86% of the Democrats opposed it. Indeed, the SH Act was in keeping with the Republican Party’s agenda after the party gained control of the Congress in early 1920 and subsequently won the presidency later the same year. Tariffs were raised by the Emergency Tariff Act of 1921, followed by the Fordney-McCumber Tariff Act of 1922, which reversed the Democratic tariff reductions in 1913 and further raised tariffs to insulate the domestic industries from European competition. The SH Act was thus just one more step among many that the Republican Party took to raise tariffs. The Republican Party’s then-protectionist leanings stemmed from President Hoover’s campaign promise to provide protection to farmers, who were excluded from the 1920s boom because farm-gate prices actually declined relative to prices of non-farm produce. This disparity had caused farm foreclosures to rise from 3.2 per thousand farms between 1913 and 1920 to 17 per thousand farms in 1926-1929. However, once the tariff-setting process got underway, the original objective was lost and what was meant as a tool to provide relief to a limited section of the economy (farmers) became a tool for an across-the-board increase in tariffs.

Secondly, duties raised under the Smoot-Hawley Act were not unduly large. The SH Act, passed in 1930 (a year into the Great Depression), raised effective tariff on dutiable US imports to 59% from 39% in 1928. However, even after the increase in tariff, effective ad-valorem tariffs were just back to the levels at the start of the century. Moreover, the Act did not change the amount of imports entering duty-free into the US (they remained at around two-thirds).

SH Act did not change tariffs radically vis-à-vis long-term rates

Source: Federal Reserve Bank of Minneapolis. Significantly, the actual duty increases under the SH Act were not extraordinarily high per se. What caused the decline in US and global trade was the specific nature of duties on almost 2/3rd of dutiable US imports. In the global deflation that followed (US import prices declined 50% between 1929-1932 according to one study), a decline in import prices pushed up the effective rate of duties (as duties remained fixed in dollar terms). A study by US Tariff commission suggests that adjusted for changes in composition and prices, effective tariff increases under the SH Act were lower than those under the 1922 Act (see table below). For example, as the price of peanut oil fell from 12 cents to 4 cents a pound over 1928-1930, the specific duty of 4 cents a pound rose from 33% to 100% in ad-valorem terms. Overall, 50% of the increase in effective tariff on dutiable imports was due to a decline in prices rather than increase in duties. Thirdly, trade was well on its way to collapse even before the Smoot Hawley Act came into effect. In 1929 for instance, US import volumes had already declined 15% (Smoot-Hawley Act came into force in mid 1930).