Trade flows lie at the heart of the global economic system. Cross-border transactions underpin the prosperity of nations, influencing anything from the current account to inflation rates. For much of the past three centuries, Europe and North America have dominated the patterns of international commerce.
But how long will this last? A surge in inter-regional trade between Asia, the Middle East, Africa and Latin America means that this supremacy may well decline in the long term. These ‘South-South’ trade flows are directed toward fast-growing emerging markets, side-stepping sluggish economies in the developed world. Moreover, they are already having formative impact on core treasury areas, such as foreign exchange (FX) management and supply chain strategies.
Emerging market exports have rebounded faster than world exports following the global financial crisis, according to a United Nations Conference on Trade and Development (UNCTAD) report in June. South-South exports increased by 30% between 2009 and 2010 alone, compared to 22% for the latter. Economic troubles in the West have spurred developing nations to realign their economic interests towards flourishing regions.
In 2010, for instance, China signed $16 billion worth of trade deals with India during a visit by the Chinese premier, compared to just $10 billion with the US when President Obama arrived in town. Brazil, Myanmar, Iran and Afghanistan all count China as their largest foreign investor, with much-needed funding ploughed into infrastructural projects that facilitate business and trade.
“The global financial crisis was a watershed moment from the perspective of increased focus and attention to South-South trade flows,” says Kah Chye Tan, Global Head of Trade and Working Capital at Barclays. “In many ways, it has been happening for quite some time. We are seeing less trade intermediation traditionally played by the European countries.”
Western governments and consumers, for their part, are busy deleveraging. As a result, aggregate demand remains weak and provides little incentive for emerging economies, such as China and Brazil, to devote substantial resources towards building trade relations down the line. Developing countries are understandably looking elsewhere for business opportunities.
“Global economic troubles have yet to subside, and that is evidenced by the challenges in Europe,” says Simon Constantinides, HSBC’s Regional Head of Global Trade and Receivables Finance, Asia Pacific. “We have started to see a knock on effect on China because of the continued slowdown on the European continent where China has large business interests. However, if you look at Asia you will find that the area is reliant on regional trade as well. Over 50% of China’s trade is with other Asian countries, for example.”
Asia blooms
In a sense, South-South trade is very much trade with, and within, Asia. UNCTAD figures suggest that Asia accounts for over 80% of all South-South exports; and that nearly three-quarters of this figure can be attributed to Asian countries trading with each other. China acts as the centre of gravity for a new pattern of commerce stimulated by rapid urbanisation rates and infrastructural developments.
Latin America and Africa, on the whole, are marginal actors – though nevertheless important ones. These regions account for 10% and 6% of South-South exports, respectively. An Ernst & Young corporate survey in 2011 pointed out that a significant portion of this inter-regional trade represents flows of goods between and within companies – such as rubber, plastics and metal products – as opposed to finished products for consumers.
“China is operating a two-way trade market with Latin America,” observes Constantinides at HSBC. “It is importing iron ore, soy and other commodities and at the same time offering a significant quantity of finished products that aims to satisfy the large consumer base in Latin America. And while there is growing potential for trade between those two regions, we also know that China and Africa have very active trade models, developing and competing with India.”
But India is no paper tiger either, argues Barclay’s Tan. “As a market, it has transformed quite nicely in the past five to ten years,” he notes. “India used to be an exceedingly closed market. There was always a lot of trade, but it was intra-India, things are changing rapidly. Indian trade flow with China has ballooned, and trade with Africa has increased too. The country has a strong competitive edge in manufactured goods and pharmaceutical products.”
Indeed, UNCTAD figures put manufactures at 60% of South-South exports. HSBC research in mid-2011 predicted that South-South trade and capital flows will jump by a factor of ten in the next 40 years. And the exact composition of that trade will likely change over time. As demand in developing regions increases, local preferences will figure in on a wider scale. The car industry is a good example. European manufacturers specialise in high-end, bulky automobiles, such as a Mercedes or BMW, that signify status as much as convenience. But Asian producers, such as the Indian firm Tata, have created a niche for themselves by manufacturing cheaper, lighter and durable cars that cater towards the needs of lower middle-class families that prize expediency over style.
With economic barriers still relatively high compared to trade policies in North America and Europe, the room for further improvements in scale and interdependency is huge. Trade is likely to flourish as obstacles to commerce become gradually dismantled.
FX risk goes red
All this is well and good. But what do these developments mean for the corporate treasurer? The revolution in trade is manifesting itself in two core spheres of treasury practice: FX risk management and supply chain management. Taken together, these two trends are influencing key aspects of the international treasury landscape.
Where there are trade flows, there are capital requirements. With the US dollar beset by a troubled North American economy, the surge in South-South trade will be a powerful factor in the continued liberalisation of the Chinese redback. Corporates have become long accustomed to trading with an FX ‘triumvirate’ of the US dollar, euro and yen. But in the medium to long term, the renminbi (RMB) may well add a new dimension to this framework, particularly given that China will play a central role in future economic growth.
Since the late 1970s, China has become the workshop of the world, producing anything from simple toys to iPods. But underneath its economy lies a paradox. To date, despite the economic and military prowess of the Asian Tiger, its currency has played a minimal role in international financial affairs. A SWIFT paper in mid-2011 highlighted the fact that the yuan made up for just 0.9% of FX trades. This figure pales in comparison to the US dollar’s 45.9% and the 16.9% of the euro.
This situation is likely to change. China acts as a magnet that attracts the resources and goods of surrounding regions, a position that affords the country a tremendous bargaining power. It is an influence that feeds into cross-border transactions, too: the RMB is already gaining ground as the currency of choice used to execute trades.
“We know that 10% of China’s trade is settled in RMB,” says Constantinides. “This illustrates that companies are now becoming more astute, focused and interested in what trading RMB can do on a competitive basis. First, they get pricing visibility, because now they can get a two-way quote in either euro or US dollar (in terms of the RMB). Second, if China’s imports are going to grow significantly, Chinese buyers are going to want to use their currency. They don’t want to go into the market as much to buy dollars when they are going to get paid in RMB; so they would rather become more comfortable in eliminating the FX risk. We believe that the redback will become more and more significant as a major trade currency.”
An HSBC survey last October, for instance, suggested that 71% of Chinese corporates expect one-third of all Chinese trade to be executed in RMB. Moreover, four out of every ten Chinese businesses were willing to offer discounts of up to 3% on trades in RMB. Treasurers need to get used to the idea that FX risk management will take on an increasingly red hue. Best treasury practice is now likely to be in tune with the latest developments of onshore and offshore RMB markets. More corporates will be using RMB to manage their FX risks, in turn bringing operational and accounting advantages while based in the region. Indeed, key management meetings are now often held in Asia as a signal of the region’s importance to some international corporates.
So far, Chinese authorities have been reluctant to ease capital controls by too much. Policymakers in Beijing are all too aware of the example set by the Asian financial crisis in the late 1990s, when neighbouring economies in south-east Asia succumbed to sudden outflows of capital and fell into economic ruin. Countries such as Thailand had liberal capital regimes that allowed investors to exit by the click of a mouse button. The Asian Tiger largely escaped the chaos given its tightly controlled redback. And as a result, Chinese authorities are still cautious about dismantling capital barriers in one fell swoop. A gradual approach to liberalisation is preferred.
Nevertheless, the redback is a currency with a bedrock of confidence. As long as there are business opportunities to be won, international companies will be willing to execute trades in yuan.
But a changed FX risk management arena is not the only symptom of South-South trade flows. Given that the RMB remains a tightly controlled currency, this will have implications for trade finance practice in developing economies. This restriction will inevitably feed into, and limit, the level of trade finance services offered by banks operating in Asia. On the one hand, corporates are lured into the region by strong demand. On the other, however, they face potential bottlenecks when it comes to executing RMB trades via trade finance instruments.
Supply goes South-South
The dynamics of supply chain management are also at the forefront of change. Emerging market prosperity has been coupled with (relatively) low wage growth, affording international corporates more attractive locations to set up shop. The appeal stems from greater political stability and hard-nosed business logic; and is strengthened by rock-bottom transport and transaction costs via air, sea and the electronic ether.
With business opportunities shifting eastward, there is an increasing incentive to shift supply chain towards the regions that matter: Asia and Latin America. This is all the more important for corporates that wish to tap into local demand in these areas. A regional supply chain allows the company to adapt quickly to shifts in the regional economy, or even changes in consumer preferences. And it can deliver large cost savings given the shorter delivery times involved.
Ernst & Young’s 2011 corporate survey contended, “the fact that rapid-growth markets, and China in particular, will represent the fastest growing source of final demand over the coming decade, will provide additional impetus for firms to locate production in the destination region to serve emerging markets more responsively.” More than two-thirds of the companies surveyed, the report went on to remark, noted that their supply chain is increasingly being developed to service their company’s growth in emerging markets.
Strong relationships and trust were found to be the key factors influencing corporate strategies. Increasingly, international corporates are becoming more comfortable with suppliers based in multiple regions as opposed to concentrating all their eggs in one basket.
But this shift, while useful, is certainly not flawless. First, delegating the supply chain to regional actors entails a loss of centralisation and direct control over suppliers and production. And second, the corporate’s reputation is at risk in case of local failures to adhere to product quality and labour standards.
On top of these two issues comes the difficulty of establishing a proper foothold into the regions. Entry to South-South trade markets can be an arduous, time-costly process – although one that is alleviated by the fact that the shift in trade patterns is likely to continue into the long run. It is a matter for corporate treasurers to weigh short-term costs against the long-term benefits, a difficult task in the current harsh business environment.
Catching up
“Trade flows are really changing,” says Tan at Barclays. “If you go back three or four decades, one leg of the transaction would have always ended up in the Organisation for Economic Co-operation and Development (OECD) market. Today you now find that one leg of the transaction will end up in the Asian market. It is very hard today to find a trade flow where one leg is not in Asia.” Many corporates would agree with Tan. Business opportunities are flowing eastwards along with trade. The only question is when corporates decide to tap into these currents.
The world economy is not a zero-sum game; the rise of the East does not necessarily come at the expense of the West. Indeed, the continued development of South-South trade can be beneficial for all parties, argues Tan. With China shifting to a consumer economy from an export-led one, international business can tap into the Asian giant’s rising tide of consumer wealth.
Emerging nations, for their part, benefit from a greater degree of economic independence. “Being able to loosen policy at a time of global economic and financial stress is a relatively new phenomenon for emerging market policy makers and it reflects improved external balance sheets, lower inflation and more flexible exchange rate regimes compared to earlier decades,” says Brian Coulton, Emerging Market Strategist at Legal and General Investment Management (LGIM).
And there is plenty of room for development. Per capita incomes, a proxy for assessing standards of living, remain rather low in China, Brazil, India and other developing economies. As trade flows persist, they will surely rise towards Western levels.
When viewed historically, South-South trade flows are just another example of an ‘economic catch-up’ at work. A millennium ago, Asia and Africa dominated the routes of world trade – at a point in time when Europe was still an undeveloped backwater. The US was a small economy in the mid-19th Century, but then went on to assume global leadership within 100 years. For now, it seems, economic affluence is swinging back to the East and it is likely to stay there for some time. Corporates should grab a hold while they can.
