The Nuts and bolts of trade

Trade Finance, Macro and Markets

The nuts and bolts of trade

September 2019

How dependent is Europe, in particular Germany, on the rest of the world to buy its machinery and engineering exports? And where do all those essential components come from? Rebecca Harding unpicks some complex supply chains

Europe is coming under pressure from all sides at present. Its model of liberal, ‘social market’ capitalism was criticised by President Putin at the G20 Summit in Osaka earlier this year,1 and the US administration has set its sights on reducing America’s trade deficit with Europe and China. On top of this, export credit agencies based in Europe say that aspirations of multilateralism and integrated global supply chains are crowding out European-funded projects.2

 

Schuler Group

Source: Schuler Group

Dr Rebecca Harding

Dr Rebecca Harding

Independent economist | CEO of Coriolis Technologies

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Zero-sum thinking?

The rumbling thunder of trade war has been reverberating around the global economy for 18 months now. Following the tentative truce agreed at the G20 Summit, negotiations between the US and China seem to have moved on from zero-sum thinking, but let’s not forget that globalisation has created interdependencies between countries and businesses so that mutually assured (economic) destruction is the consequence of a strategy based on ‘I export more, you export less; therefore I win, and you lose’. The result is a dangerous, but ultimately stable, equilibrium where neither side triggers an all-out trade war, because to do so would be the economic equivalent of pushing the nuclear button.

 

Schuler Group
Source: Schuler Group

This does not mean that there will not be conflict or, indeed, that the impact of these conflicts will not be global. The US negotiating stance is common across all its trade discussions, not just those with China. Alleged intellectual property theft, cyber security breaches and the perceived national security risk of Chinese technology within US business information systems are all part of the negotiating process, as are agriculture, manufacturing, the US trade deficit and public services. Even monetary policy is part of the process, since the US will make perceived currency manipulation through interest rates or market intervention a pillar of any settlement. This will all be outside the World Trade Organization (WTO), of course.

 

Schuler Group
Source: Schuler Group

Trade surplus tensions

This creates an existential challenge for Europe. The European model of capitalism is under attack from all sides, and the traditional ‘nuts and bolts’ engineering-based trade that it does is threatened. It does not have a different, or indeed strategically competitive, economic system with which the US feels compelled to do battle. Yet the EU itself is seen as a ‘mercantilist trading bloc’ by the US administration.3 What this means is that trade is being conducted by it in a way that promotes its interests and on its terms. So the tug of war between Europe and the US is not about economic systems, as it is with China, it is about trade surpluses.

 

Derpag Schulz
Source: DERPAG SCHULZ GMBH U. CO.

Take heavy engineering (proxied through machinery and components) as an example. Europe’s exports to the rest of the world accounted for US$1.46trn in 2018. This is around a third of the total global trade in the sector of US$4.4trn. The breakdown by country explains why Europe has pole position. Germany, Italy, the UK and the Netherlands are the four largest exporters in the sector and, combined, their exports are US$698bn, compared to China’s US$669bn (see Figure 1).

In the current environment, size appears to be everything because it determines the strength of the negotiating stance. But it is also about depth. Europe’s strength lies not just in the fact that it contributes such a large proportion to the total in machinery and engineering, but also because it has complementary sectors that work together. Heavy engineering, for example, works with electrical engineering, iron and steel, precious metals (because gold and platinum are important aspects of electronic and automotive equipment for example) and automotives to produce a picture of a net surplus for the EU’s external trade everywhere except with China and Japan (see Figure 2).

STAHL CraneSystems GmbH
Source: STAHL CraneSystems GmbH

German machine power

According to GTAI Germany Trade & Invest, Germany’s machinery and equipment (M&E) sector is “the world’s leading supplier of machinery with 16% share of global trade”. It also states that “German manufacturers are also the world leaders in 19 out of 31 M&E sectors in global comparison”, and notes that German M&E industry strength is driven by a combination of the country’s “proven engineering tradition, its position as a technology development leader, and a highly diversified industrial base”.4

 

While the US and China are the predominant trade partners in the sector, Germany has nevertheless drawn the ire of the US because of the size of its trade surplus, and equally because of its contributions to NATO.5 Germany has a long tradition in engineering and accounts for some US$681bn of exports in the combined engineering-related supply chain, compared to the US’s US$623bn. According to the US, much of this is because of its “unfair practices”.6 Of the EU countries in this sector, Germany is dominant and it’s worth focusing on this aspect of the sector to see where the problem lies.

16%

The share of global trade held by Germany’s M&E sector

(GTAI Germany Trade & Invest)

After all, when Angela Merkel starts talking about a “strategic competition”, as she did at the Munich Security Conference this year,7 there is clearly a shift in her perception of the political landscape as well as the world of trade within it.

Within the engineering sector, Germany’s power is really in its exports of machinery and components and automotives. In order to fuel this supply chain (see Figure 3), it has a trade deficit in iron and steel, electrical equipment and precious metals (especially gold and platinum).

At present, the US iron and steel tariffs are imposed on iron and steel going into the US. However, because Germany’s supply chains are largely from within Europe, its engineering and automotive sectors are unlikely to be substantially affected by this move.

 

By way of example, Germany’s trade in the engineering sector has grown over the period between 2013 and 2018, particularly with Spain, Poland, the UK and the US in terms of exports, and with Poland, the US and China in terms of imports (see Figure 4).

What is clear is that imports from the US are growing more quickly than exports to the US across the sector as a whole, while exports to China have dropped back considerably, perhaps because of the economic challenges that China has faced in the wake of the US trade war and general global uncertainty. What is perhaps more interesting from this chart is that although trade with Poland has increased, trade with other countries within Europe has fallen back, suggesting that Germany may be redistributing its supply chains within Europe in favour of Eastern European nations. Poland has been a particular beneficiary of this.

The engineering sector is Europe’s largest combined export grouping, and Germany is its major player. The problem for Europe is that, although there is indeed a surplus with the US in automotives and machinery and components, the sector itself relies heavily on imports both from within Europe and, ironically, the US and China as well. There is a misconception that because the end (value-added) products, such as machines and automotives, have a trade surplus, this is a ‘bad’ thing. Actually, because the production of final goods relies on imports – of iron and steel, metals and electronics as well – such a misunderstanding of how trade works could undermine the potential of cross-border supply chains.

 

Cranking up

"The tug of war between Europe and the US is about trade surpluses"

Europe’s engineering sector is projected to continue its steady growth at around 1.5% annually to 2022 and, given its size in the world, this is substantial. Europe’s strength rests in traditional manufacturing sectors: heavy engineering, automotives, pharmaceuticals and aerospace. Supply chains in these sectors are global and cross-border trade is essential.

A high level of imports is a measure of strength rather than weakness so, although Germany exports more cars and machinery and components, it imports more electronics and iron and steel. This is the simple truth of comparative advantage and goes back to the basics of free trade. A country imports when it is cheaper or more effective to do that rather than produce itself. Europe is an excellent example of how this works.

 

This does not mean that Europe can rest on its laurels, however. Trade wars, even if they remain largely rhetorical, are not going to go away. Europe cannot act as strategically as either the US or China because it is not a nation state – it is a trading bloc.

As a result, it has to empower the competitiveness of its member states and help them to enable growth on a multilateral basis, rather than the bilateral style of negotiating that we are currently seeing. The EU has a strong interest in helping the WTO to sharpen its regulatory and dispute resolution teeth. Together with Germany, its strengths are less strategic and more about the nuts and bolts of trade. At the moment, that is what really matters.

Dr Rebecca Harding is an independent trade economist and CEO of Coriolis Technologies

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Sources

1 See https://on.ft.com/2NuZo7G at ft.com
2 Author’s own interviews
3 The US National Security Strategy, December 2017, refers to ‘mercantilist trading blocks’ generically to mean the North America Free Trade Agreement (NAFTA) and the EU in particular
4 See
https://bit.ly/1CtXCTk at gtai.de
5 See
https://on.ft.com/2xulVGU at ft.com
6 See
chathamhouse.org
7 See
https://bit.ly/2XHNM4T at securityconference.de

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