Devaluation & the “Commodity Trap”

6 April 2016


Introduction

In the third of our articles on devaluation we assess whether devaluation of the Trinidad and Tobago dollar against other major trading currencies is inevitable and we assess the consequences of such a devaluation in the event that the government decides to devalue the Trinidad and Tobago dollar, or is forced into doing so as a result of economic circumstance, and on the exhausting of foreign reserves.

The genesis of the problem – you may never have had it so good!

The current slump in commodity prices – and for Trinidad and Tobago we are referring to oil, gas and other commodity products like LNG, Methanol, and Ammonia- has its genesis in at least five events that have combined over a short period of time to greatly reduce commodity prices across the board for nearly all products. All of the following have certainly contributed:

  1. China Syndrome and going South: It is probably true to say that the current sustained slump in commodity prices caught everyone off guard – at least initially. For a number of years, the demand for commodity products had surged and was primarily driven by the rapid economic growth of China. As China embarked on a process of industrialisation, urbanisation, and massive investment in infrastructure, its demand for building products like steel, aluminium, copper, as well as energy in the form of oil, gas and LNG grew exponentially and those countries that could supply the demand for those commodities reaped the obvious benefits. The simple fact is that today China is by far the largest consumer of commodities across the board.

But the fact that growth in China has for the large part driven economic growth in the rest of the world is in itself a problem because when the economy in China started to slow and inevitably demand for commodities also started to slow, commodity prices were only going to go in one direction – South.

The devaluation of China’s currency on August 11th 2015 by two percent – the largest devaluation in over two decades – created a self-perpetuating fear that the Chinese economy was continuing to slow. On August 24th 2015 stock markets in London, Frankfurt, Paris and the United States all fell sharply as the Shanghai Composite tumbled by nearly 9%. The effect on Wall Street was cataclysmic with the Dow Jones falling by nearly 4% (experiencing its worst day in over four years).

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  1. The Rise of Shale: The rise of Shale gas as an alternative energy source particularly in the United States has helped to shift the balance of power away from OPEC.

 

  1. A Deeply Divided OPEC: The lack of cooperation amongst the OPEC nations as key-members like Saudi Arabia are prepared to suffer lower prices in an attempt to protect current market share, and oil output ramps up in Iraq and Iran. High cost producers like Venezuela and Russia continue to suffer as a result of low oil and gas prices.

 

  1. Economic Hangover and the rise of Austerity: The continued impact of the World Financial Crisis that commenced in 2007 and has led to sustained periods of austerity and recession in the United Kingdom and Europe.

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       5. Faltering Emerging Markets: All of the above has had a detrimental effect on the development and growth of economies in emerging markets, many of whom are also significant commodity exporters.

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Will it get better quickly – confidence is everything?

The short answer to this is that probably it won’t get better in the short term.

The fall in the European and US stock markets reflect and measure both international investors’ confidence and uncertainty over how well China can address the economic problems it faces. These include bolstering its own stock market, and reversing the significant decline in productivity experienced in 2015 and the first quarter of 2016. Growth in GDP has been at its slowest in over six years, and with investment, perception and confidence is everything.

Relying on commodities like oil and gas is no golden path to sustained prosperity

The lesson for Trinidad and Tobago – and most of us already knew this – is that relying on the exports of commodities like oil, gas, and LNG is no golden path to sustained prosperity.

Falling into the “commodity-trap” (relying on exports of commodities to drive the economy forward) may give steady periods of growth and prosperity when prices are high, but the economy will remain weak and vulnerable when prices fall. One of the major shortfalls of oil and gas is that it doesn’t employ large numbers of people, it doesn’t allow for the large scale “skilling-up” of the workforce, and it doesn’t promote investment in plant and machinery that can be used in manufacturing processes outside of the oil and gas sector. Spending large amounts on education programs like G.A.T.E. (Government Assistance for Tuition Expenses)  is all very well, but what is equally important is having jobs for a skilled work force to enter into.

The secret is to diversify the economy away from oil and gas – at least in part. It is also to recognise that oil and gas is the strength of the economy and it would be stupid to ignore it. If Trinidad has failed in any area, it has failed in attracting new enterprise into the country (particularly in the area of manufacturing) that takes the plentiful energy supply and turns it into real and diverse value added product. Production of methanol, ammonia, and urea have been a stumble in the right direction but what is needed is value-added large scale manufacturing in areas that are not heavily linked to oil and gas but benefit from low cost energy inputs.

Investors – so it seems – are only interested in taking our oil and gas and doing minor conversions to it. If Trinidad and Tobago has failed in any (other) area, it has failed in attracting foreign investors into the country to develop sectors other than oil and gas. It’s a pity because the people have much to offer and deserve better.

We are not alone

All commodity exporters are suffering at the moment. This includes Canada, Australia, Chile and large chunks of the former Soviet Union. Some have had to devalue their currencies as a result of low commodity prices the most recent being Kazakhstan. If you want some measure of how much these currencies have devalued, the Russian ruble has fallen 46% in the last twelve months and the effect in Kazakhstan of allowing the Tenge to float was an immediate 23% fall in value against the United States dollar. In Chile the depreciation of the peso is reaching 40% following on from earlier devaluations in 2013 and 2014.

What happened in Kazakhstan could also happen in Trinidad and Tobago

Kazakhstan, a former member of the Soviet Union has enjoyed a decade and a half of economic growth. By 2006 in economic terms it had become the dominant nation of Central Asia producing over 60% of the regions GDP. Its economic fortune derives from its great mineral wealth which in itself is dominated by oil and gas.

As the price of commodities has fallen and remained low for a sustained period, the government of Kazakhstan decided to let its currency float freely without government intervention.

Part of the reason for allowing the currency to float and effectively devalue was because China (a major trading partner) had already devalued its currency, but also because oil prices had tumbled and sanctions against Russia over the conflict in the Ukraine had driven the Russian ruble down 46% in 12 months. In 2014 and 2015 the Central Bank of Kazakhstan had spent $28 billion defending its currency but by August 2015 could no longer do so. The President of Kazakhstan told his people that they must learn to live with oil at a crude price of $30-40 dollars per barrel and save their reserves so far as possible.

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The effect of all this and why we should fear devaluation

Trinidad and Tobago derives most of its export earnings and foreign currency reserves from the sale of oil and gas. These sales are denominated in United States dollars.

Most of the items that we consume are imported into the country. This includes cars, clothing, luxury items, and a significant portion of the food that we eat. These items have to be paid for by using the foreign currency reserves earned from oil and gas.

As noted in a previous blog entry in this series, Trinidad and Tobago operates a managed exchange rate. Although the rate can fluctuate it is managed by interventions from the Central Bank. In times of high demand, the Central Bank releases additional supplies of United States dollars into the system mopping up excess liquidity in the form of Trinidad and Tobago dollars. In 2014 and 2015 the Central Bank of Trinidad and Tobago released the following amounts into the system by way of special intervention:

 

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At the date of the final intervention in October 2015 the foreign reserves of Trinidad and Tobago stood at US$10.1 billion. This is enough to cover imports for 12 months at predicted levels of consumption. The latest disclosed figure at the time of writing (February 2016) indicates that reserves have fallen to US$9.4 billion representing 11 months import cover.

So should we fear a possible devaluation?

If the amount that we spend on imports into the country continues to outstrip the amount of foreign exchange that we earn from our exports (mainly from oil and gas) any shortfall has to be paid for from our foreign reserves. If those reserves are quickly exhausted the exchange rate will inevitably face significant pressure and devaluation would be inevitable.

There is another simple lesson here: We need, to a very great extent, to learn to live within our means especially in times of recession. If we keep spending, the reserves will inevitably be exhausted.

Closing thoughts

Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector. Firstline offers a number of unique opportunities to put surplus cash to work either as your asset manager or investment advisor. Please contact us for more details at info@nullfirstlinesecurities.com or at 868.628.1175, we can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you.

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