THE SLOWDOWN IN GLOBAL TRADE AND LITHUANIA’S EXPORT POTENTIAL

T.E.H. NottenAnalyst

Enterprise Lithuania

May 19, 2016

Vilnius

• According to WTO data, global trade volumes grew only 2.8% in 2015.• This was the fourth year in a row that global trade volume growth remained below 3%, while

before the crisis (between 1995 and 2008) global trade volumes increased around 6% annually.

Global trade growth slowdown

7.7%

5.1%

9.3%

4.5%5.4%

10.9%

-0.3%

3.2%

5.7%

10.1%

6.3%8.5%

6.3%

2.2%

-12.6%

13.9%

5.3%

2.2% 2.4% 2.8% 2.8%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Annual global merchandise trade volume growth, %

Source: World Trade Organization

• Global export and commodity prices reached their peak in 2011 and have been gradually declining ever since.

• The decline accelerated in 2014 in all categories.

Deflationary global trade and commodity prices

0

50

100

150

200

250

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Global trade and commodity prices in USD (2005=100)

Manufactures Fuels Primary commodities excluding fuels World trade

Source: Netherlands Bureau for Economic Policy Analysis

• Ministry of Finance twice a year requests forecasts for Lithuanian exports from Enterprise Lithuania

• Three econometric models are used that separately forecast:

1. Domestically produced exports excluding energy products (publishedin 2012)

2. Re-exports of goods excluding energy products (published in 2015)

3. Exports of services (forthcoming)

• Exports of energy products are excluded due to their different production structure (abundance of capital, hardly any labor) and the high amount of contractual obligations.

Enterprise Lithuania’s econometric modelsused for forecasting exports

• Thomas E.H. Notten (2012), The role of supply and demand factors for Lithuanian exports: an ARDL bounds testing approach, Pinigų studijos, Volume XVI, Nr. 2, pp. 20-39

• Thomas E.H. Notten (2015), The economic importance and determinants of Lithuanian re-exports, Pinigų studijos, Volume XVII-XIX, Nr. 2, pp. 1-20

5 CPB-modellen - NOSMO

Inputs for exogenous variables

Outside modelinformation

Historical data Parameters

Residuals of behavourial equations

Model forecast

Publication of forecast

Models

Expert opinion

Enterprise Lithuania’s forecasting process

• Model uncertainty

• Incorrect inputs for exogenous variables

• Most recent ‘provisional’ data incorrect

• Model outcomes unnecessary overruled

Reasons for forecasting errors

Model for domestically produced exports (2012)

• Lithuanian exports are generally believed to be sensitive to economic growth in export markets. This belief is based on:

– casual observation, especially from recent recessions– Previous studies and discourse in mass media

• Previous studies that do exist focused solely on export demand relationships• These models have generally been unsuccessful in explaining long-run trends in export

performance• Part of the problem might be due to the omission of supply side factors• We found that supply factors are more important for explaining long-run export performance

than demand side factors, which is due to Lithuania being a price-taker in world markets • This means our prices co-move with world prices and we are too tiny to influence these prices.• Instead our long-run export performance is determined by productive capacity. Lithuanian

exporters can basically supply as much as they like, as long as they don’t exceed the global price level.

• Hence, export margin very important for export and investment decision of exporting firm. Excessive wage growth therefore potentially harmful for export development.

• Other important supply factors are availability of credit for investments and skilled labour• Developments in foreign demand and export prices relative to competitor prices are main drivers

of domestically produced exports in the short-run.• Export prices depend on competitor export prices, on import prices of raw materials and

intermediate goods and on unit labor costs in manufacturing.

Models for re-exports (2015) and exports of services (2016)

• Re-exports are goods previously imported from one country and exported to a third country without further processing.

• The main driver of Lithuanian re-exports are imports in re-export markets, which are in turn determined by the level of economic activity in these markets. The most important re-export markets are Russia, Belarus, Latvia and other former Soviet Union countries.

• Relative prices, which reflect the relationship between re-export prices and competitor countries’ export prices, is an indicator of international demand for re-exported products, rather than of the competitiveness of the Lithuanian re-export sector. Supply factors, such as relative unit labor costs or potential production play no direct role in explaining re-export volumes because by definition re-exported products are not produced by Lithuanian firms.

• Prices for re-exports are determined by import prices of re-exported goods and competitor prices.

• Exports of services depend on imports in export markets for services both in the long run and short run. Exports of services are dominated by transportation and logistics services accounting for more than half of all exports of services with Russia and Belarus as the most important market.

• Lithuanian export of services depend on export prices of services relative to competitor export prices and on unit labour costs in services.

• Export prices of services are determined by competitor prices and on unit labour costs in services.

• European economic growth continues at a moderate rate. Important export markets such as Germany, Sweden, Poland, Latvia and the United Kingdom report robust growth figures.

• On the other hand, traditional Eastern markets are in turmoil with deep recessions in Russia, Belarus and Ukraine.

• Imports of food products by Russia continue to be banned at least until August 5, 2016.• Currencies of CIS countries strongly depreciated vis-à-vis the Euro, making Lithuanian products

expensive in these markets. • The ECB quantitative easing policy weakens the Euro, making Lithuanian products cheaper in

certain markets. • Stock market and exchange rate volatility is high, increasing uncertainty and business confidence.• The refugee crisis resulted in a temporary suspension of the Schengen agreement in several

countries, such as Sweden, Denmark, Austria and Belgium. • A possible withdrawal of the United Kingdom from the European Union looms over the market as

a result of a July 2016 referendum deciding over “Brexit”.• Global trade contracted during the first half of 2015, but saw a slight recovery during the second

half of the year. • Global commodity prices have been declining now for several years and show no signs of recovery

in the short-run. • Global manufacturing prices denominated in US dollars have also strongly declined in 2015.

International environment

• Empirical evidence shows that in the long-run, domestically produced exports (excl. energy products) are determined by supply-side factors such as production capacity and labor costs.

• In 2015 investments in manufacturing equipment increased with an impressive 23% (in real terms). This strongly increases the capital stock and thereby the production capacity of the tradable sector.

• Unit labor costs in manufacturing have strongly increased in recent years and this increase is expected to continue in the foreseeable future. With the current trend of declining export prices, high growth in manufacturing unit labor costs is likely to undermine competitiveness of Lithuanian labor-intensive exporting industries.

• Similar to export prices, prices of tradable goods in domestic market are declining as well, even at a faster rate. Lower prices in domestic markets vis-à-vis export markets might influence export decision of certain firms that are able to sell their products in the domestic market as well in a positive way.

• Costs spend on energy and raw materials have strongly decreased due to lower energy and commodity prices. This decreases total costs for exporting companies, but it needs to be taken into account that foreign competitors face a similar advantage. Recently, import prices of raw materials and intermediate goods have gone up slightly again.

Domestic factors

• Lithuanian produced exports excl. energy products forecasted to grow in 2016 with 5.0% in current prices, compared to 2.6% growth in 2015. Forecasted 2017 growth: 5.7%.

• During the first three quarters of 2015 relevant world trade volumes unexpectedly contracted, but saw a rebound in the fourth quarter. Due to robust growth prospects in Lithuania‘s main European export markets, the potential market for Lithuanian produced goods is expected to expand.

• The potential export market is measured by a composite indicator of import volume developments in Lithuania‘s most important export markets, double reweighted by the share of the export partner and commodity group in domestically produced exports excl. energy products.

• Separate regressions of import volumes on GDP (forecasts) for Lithuania’s most important export partners estimated to determine import volume growth. Quarterly GDP forecasts sourced from European Commission and Euromonitor International.

Domestically produced exports

Quarterly changes in relevant world trade volumes (year-on-year)

Source: Enterprise Lithuania calculations based on data from Eurostat Comext, Statistics Norway, Russian Federal Customs Service, OECD, Federal Reserve economic data

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Relevant world trade volumes Forecast

• Export prices grew year-on-year during the third and fourth quarter of 2015, but are expected to decline again in 2016 and only recover during 2017 due to low global commodity prices.

• On the other hand, competitor prices and prices of imported raw materials and intermediate goods have been growing at a faster rate than export prices.

• Strong increase in unit labor costs in manufacturing negatively affect export margins, especially for labor-intensive industries.

• The export decision of manufacturers that are also able to sell their products on domestic markets is affected by faster decreasing prices of tradable goods in the domestic market compared to the less strong decrease or even growth of export prices.

Price and cost developments

Quarterly price and cost changes related to domestically produced exports (year-on-year)

Source: Enterprise Lithuania calculations based on data from Eurostat Comext, Statistics Norway, Statistics Lithuania

-15%

-10%

-5%

0%

5%

10%

15%

20%

I II III IV I II III IV I II III IV I II III IV I II III IV

2011 2012 2013 2014 2015

Unit value index of domestically produced exports excl. energy products

Unit value index of imports of raw materials and intermediate goods

Producer prices for manufacturing for the domestic market excl. refined oil products

Competitor prices for domestically produced exports excl. energy products

Unit labour costs in agriculture and manufacturing

• This year, re- exports excluding energy products forecasted to grow 4.6% in current prices, compared to a decrease of 11.5% in 2015. For 2017, a growth is expected of 2.0%.

• Volume growth of re-exports excl. energy products sensitive to economic developments in Russia. Currently, Russian economy is in recession and prospects for remaining of the year not promising.

• There has been downward pressure on re-export prices as well although there are signs of a recovery, but re-export prices move in tandem with prices for imports for the purpose of re-export. Note that competitor prices have started growing year-on-year again. Devaluations of the Russian and other CIS countries’ currencies put an additional downward pressure on re-export price developments.

Re-exports

Quarterly price and cost changes related to re- exports (year-on-year)

-6%

-4%

-2%

0%

2%

4%

6%

8%

I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV

2010 2011 2012 2013 2014 2015

Unit value index of re-exports excluding energy products

Unit value index of competitor's exports excluding energy products

Unit value index of imports for the purpose of re-exports

Source: Enterprise Lithuania calculations based on data from Eurostat Comext, Statistics Norway and Statistics Lithuania

• This year, exports of services forecasted to grow 8.3% in current prices, compared to growth of 6% in 2015. For 2017, a 7.3% growth is expected.

• Volume growth of exports of services slowed down last year due to recessions in traditional Eastern markets Russia and Belarus, but turned out to be remarkably resilient to the contraction of income in its two most important markets.

• Export prices of services follow developments of services prices both in Lithuania and abroad. While prices of goods (imported and consumed) tend to keep on declining, prices of servicesprovided in Lithuania slightly grow and so do prices of exports of services.

Exports of services

Positive risks• Based on forecasts of other institutions we assume that commodity prices will not grow in the

short run. Export turnover will be higher if commodity prices turn out to be higher.• Due to the volatility of the Euro/Dollar exchange rate, we made no assumptions on the expected

exchange rate and fixed it at the current value (1.10 USD for 1 EUR). If the dollar appreciates, commodity prices will also increase, which will have a positive impact on export turnover. On the other hand, a dollar appreciation makes imported raw materials used in the production for exports more expensive.

Negative risks• The highest and most likely risk concerns the (temporary) abolition of parts of the Schengen

agreement. In that case border controls among European Union countries will be re-imposed. This scenario will certainly harm trade and will especially hit transportation companies.

• Another risk is the position of the United Kingdom in the European Union. Possible outcomes of a Brexit might be protectionist measures imposed by both the UK and the EU towards each others products and services. Another outcome which is already happening is a strong depreciation of the British pound, which makes Lithuanian products relatively more expensive in Britain.

• A possible further slowdown of growth (China) or deepening or prolonging of recessions in emerging markets (Russia and rest of CIS).

• The European banking sector remains vulnerable, which in case of a negative shock is likely to lead to real economic consequences related to credit provision.

• Decreasing confidence as a result of the foregoing negatively affects Eurozone economic growth.

Risks and uncertainties

• For forecasting three econometric models have been used:1. Domestically produced exports excluding energy products (published)2. Re-exports of goods excluding energy products (published)3. Exports of services (forthcoming)

• Major issues during this forecasting round:– Continual decrease of export prices with the exception of services– Emerging markets turmoil (Russia, CIS) and uncertainty (China)

• Uncertainties/risks– Possible United Kingdom withdrawal from the European Union after June referendum (Brexit)– Possible suspension of the Schengen agreement due to refugee crisis– Deterioration of situation in emerging market economies

• Domestically produced exports of goods excl. energy products in current prices expected to grow in 2016 with 5 %, re-exports (excl. energy products) 4.6 % and exports of services 8.3 %.

Summary

Period

Indicator

2014 2015 2016F 2017F

Domestically produced exports of goods excluding energy products 4.4% 2.6% 5.0% 5.7%

Re-exports of goods excluding energy products 8.1% -11.5% 4.6% 2.0%

Exports of services 8.5% 6.2% 8.3% 7.3%