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The Structure of the Currency Game

Definition of Volume of Trade

Patterns in Volume of Trade by Country GDP

Patterns in Trading Partners



In my previous blog entry, “Making Sense of the Currency Wars”, I discussed the basics of exchange rates – how they’re defined, how they’re determined, and the pros and cons of having a strong or weak currency – and I discussed currency wars – how they work and how they affect participant economies. I also defined how currency (exchange rate) wars form a game between countries, where the losses of losers would appear to far outweigh the gains of winners. In this blog entry, I take a closer look at the currency game.

The Structure of the Currency Game

The structure of the currency game is determined by the magnitude and direction of trade (exports and imports) between countries (blocs) with different currencies; that is, the structure of the game is determined by (i) who trades with whom and (ii) how much is exchanged.

Who a country trades with and how much they trade will depend on several factors, including

•  What goods and services different countries produce (comparative advantage ~ relative prices)

•  What different countries’ needs are (supply vs. demand)

•  How far apart different countries are (transportation costs)

•  What the exchange rates between countries are (relative prices)

The greater is the volume of trade (exports and/or imports) between two countries (blocs), the greater will be the impact on those two countries’ imports and exports resulting from any changes in the exchange rate.


Definition of Volume of Trade

The term “volume of trade” could refer either to absolute or to relative volumes of trade. Absolute volumes of trade are measured by countries’ total exports, X, and total imports, M:

Country’s Absolute Volumes of Trade = X, M;

whereas relative volumes are measured as absolute volumes relative to countries’ GDPs:

Country’s Relative Volumes of Trade = (X / GDP), (M / GDP).

A few brief points of note:

•  Countries may very well run trade surpluses (X > M) or trade deficits (X < M) for short periods of time. However, theoretically, over the long run, any imbalances should be forced away, so that the value of a country’s total exports over time will equal the value of its total imports (valued in country i’s currency, where Eijt is the exchange rate between country i and country j at time t):

In reality, though, different types of political relationships between countries enable countries to maintain trade imbalances with particular trading partners for significant periods of time.

•  In any given period, one country’s exports is another country’s imports, so total global trade is a zero-sum game (valued in a numeraire currency):

•  However, comparative advantage and gains from trade mean that in any given period, total global consumption in a world with trade is greater than total global consumption would be in a world without trade (valued in a numeraire currency):


Patterns in Volume of Trade by Country GDP

Q: Are the countries that are largest in terms of GDP the same counties that have the largest absolute or relative volumes of trade?

A: The data show that the countries that are largest in terms of GDP are generally the countries with the largest absolute trade volumes, but they are not the countries with the largest relative trade volumes.

The World Factbook of the CIA provides country level data on (i) GDP, (ii) total imports (M), and (iii) total exports (X). I used these data to calculate relative exports (X / GDP) and relative imports (M / GDP) for each country. Figure 1 displays the summary distribution of global exports (X), imports (M), and GDP across large (2011 GDP > $1T), medium ($1T > GDP 2011 > $100B), and small sized countries ($100B > 2011 GDP).

Figure 1

Figure 1 shows that the largest 12 countries combined – where country size is measured by GDP -- account for 79% of 2012 global GDP, 70% of global exports, and 74% of global imports. In other words, the largest countries tend to export and import slightly disproportionately less than their shares of income would suggest. The figure further shows that it is the 41 medium-sized countries that are offsetting the trade imbalance of the largest countries. That is, while the medium sized countries jointly account for 18% of global income, they account for disproportionately more exports, 26%, and imports, 22%.

Figure 2 displaysthe scatter plots of relative exports against relative imports separately by group size.

Figure 2: Scatter Plots of Exports vs. Imports

The data in Figure 2 show that

•  The larger countries tend to trade relatively less (though the data show they trade absolutely more) than most medium and small countries.

•  The larger countries have more balanced trade, that is, exports more closely approximate imports, than that for most medium and small countries.

•  The countries with large excess exports tend to be oil countries.

Now that we see that many of the countries that are relatively heavy exporters are oil countries, let’s exclude those countries from the results in Figure 1 and see what we get. The medium sized oil countries are Iran, Saudi Arabia, Nigeria, Norway, Algeria, UAE, Qatar, Kuwait, Angola, and Cuba. Figure 3 presents the same information from Figure 1, after excluding the oil countries.

Figure 3

Figure 3 shows that if we exclude the oil countries from the analysis, then

•  Relative exports approximately equal relative imports for large countries and for medium sized countries; that is, the oil countries are the ones with disproportionately large trade surpluses (X > M).

•  The largest countries (still) tend to export and import slightly less than their shares of income would suggest, while the medium sized countries (still) tend to export and import slightly more than their shares of income would suggest.

So the data show that medium-sized countries tend to rely relatively more on trade than do large countries.


Patterns in Trading Partners

Let’s move on from volume of trade to trading partners. Start first with the countries/blocs with the largest amount of trade and let’s see who their trading partners are.

Note that I have switched here from defining country/bloc size based on GDP to defining country/bloc size based on absolute trading volume, X + M.

Figure 4 provides a list of the world’s largest traders, together with information on their GDP, currency, and trade volume.

Figure 4

The trading bloc formed by the 27 countries in the European Union, known as EU27, represents the largest trading volume (exports plus imports) by a single bloc, $11.3 T in 2012, or 31% of global trade ($36.6 T in 2012). However, the EU27 consists of countries that use different currencies. If we consider only those countries within the European Union that use a single currency, then we are left with 21 countries comprising the Eurozone, which represent a total of $8.4 T in total trade, or 23% of global trade.

An analysis of the Currency Game would ideally consider the Eurozone as a single bloc (player), with Hungry, UK, the Czech Republic, Sweden, Romania, and Poland each as separate players, since they each use different currencies. However, trade data are aggregated for the EU27 bloc as a whole, rather than for only for the Eurozone countries. As such, the analysis presented below considers EU27 to be a single player, rather than the ideal, 7 distinct players. Since it is such a large country, however, I do provide information separately for the UK, in addition to information for EU27.

The other players in the Game are (see Figure 4): the US, China, Japan, South Korea, Canada, Hong Kong, Russia, Singapore, India, Mexico, Switzerland, Taiwan, Australia, Saudi Arabia, and Brazil. These 16 players jointly account for 81% of 2012 global trade.

Now that we have a list of the largest trading countries/blocs, the next step is to see who they trade with.

The European Commission provides country level data on who trades with who and how much. The data show that for the 16 largest countries/blocs identified in Figure 4, excluding Taiwan, for which data weren’t available, each country/bloc has roughly the same pattern of trade: a large number of trading partners with whom they trade a small amount and a few partners with whom they trade a large amount (see Figure 5). In other words, for large countries the relationship between number and size of trading partners may be defined by a power law.

Figure 5

Does the same pattern hold true for smaller countries? I looked at the trading patterns for a sample of smaller countries (Ecuador, Egypt, New Zealand, Suriname, Uganda). It appears that the same pattern in trading partners – a large number of trading partners with whom they trade a small amount and a few partners with whom they trade a large amount – also applies to smaller countries. There appears to be only one difference between patterns of trade for large countries and patterns for small countries: The larger countries all have the same large trading partners – EU27, US, and China – whereas the smaller countries may also have other (local) partners among their largest trading partners.

Figure 6 presents a visual perspective of who’s trading with who and how much. The size of the country/bloc nodes are proportional to the country’s total trade volume, X + M. As mentioned above, with 31% of the total global trade volume, EU27 has the largest trade volume of all countries/blocs. The US has only a slightly larger trade volume than China, $4.0T (10.8% of global trade) for the former versus $3.8T (10.4% of global trade) for the latter. Japan is the fourth largest trading county/bloc, with $1.65T, or 4.5% of global trade. Together, EU27, the US, China, account for 52% of global trade. If we add in Japan, the largest four trading countries/blocs account for 57% of global trade.

Figure 6: Trade Flows between Countries


The size of each arrow represents the relative volume of a country’s trade that is exported out of or imported into that country to or from another. For example, the large blue arrow from Canada to the US indicates that more than 50% of Canada’s exports flow to the US, and the large orange arrow from the US to Canada indicates that more than 50% of Canada’s imports also come from the US.

The visual display illustrates two phenomena in particular:

•  The largest trading countries/blocs, are all heavily connected to one another -- as well as to many other smaller countries -- via exports and imports.

•  Certain countries are satellites of other countries, in the sense that each satellite relies on a dominant country for a majority of its exports and imports. In particular

o   Canada and Mexico are both satellites of the US

o   Hong Kong is a satellite of China

o   Switzerland is a satellite of EU27

These two phenomena have two important implications regarding countries’ exchange rate policies:

•  Increases in strength or weakness of a dominant country’s currency will have a momentous impact on trade flows to and from satellite countries.  In particular, in light of the recent slide of the Euro due to the financial crisis, Switzerland’s exports to Euro countries have been seriously impacted. This explains Switzerland’s response of weakening the Swiss Franc in an attempt to counter the recent decreases in Swiss exports Swiss exports to the Eurozone associated with rising prices of Swiss exports in euros.

•  The tremendous connectedness of EU27, the US, and China to so many countries means that any increases in the strength or weakness of the Euro, the US dollar, or the Chinese yuan will have a tremendous impact on global trade. Changes in the strength of the Euro, dollar, or yuan, in turn, may lead to any number of potential reactions and follow-on reactions (e.g., changes in currency or trade policies) from trading partners. The complexity of patterns in global trade mean that ultimately, it would be extremely difficult to predict the eventual outcome of any change in the strength or weakness of the Euro, the US dollar, or the Chinese yuan on global currency or trade policies and/or on global trade.

Additionally, earlier we found that medium-sized countries tend to rely relatively more on trade than do large countries. A third implication would thus be that any currency war – which would necessarily affect medium sized countries through the global connectedness of countries through trade– would affect the economies of medium countries disproportionately more than it would large countries.

There are two issues raised in the analysis that remain unexplained, but whose answers lie outside the scope of this analysis:

•  Why do medium-sized countries, where size is based on GDP, trade disproportionately more than large countries do?

•  Why do patterns in numbers of trading partners, together with associated volumes of trade, follow a power law?

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