The euro and the British pound, Europe’s top two currencies, extended gains Thursday as investors focused on recent central bank comments about the possibility of tighter monetary policy. Stocks were mixed ahead of U.S. economic data, including the latest revision to first-quarter growth.
KEEPING SCORE: In Europe, Germany’s DAX fell 0.1 percent to 12,631 while the CAC 40 in France fell 0.6 percent to 5,225. The FTSE 100 index of leading British shares was 0.5 percent lower at 12,631. Wall Street was poised for a solid opening, with Dow futures and the broader S&P 500 futures up 0.2 percent.
EUROPEAN CURRENCIES: European currency markets have been volatile in recent days after leading central bankers appeared to hint to a turn in monetary policy soon. European Central Bank President Mario Draghi was upbeat about growth pushing up inflation, prompting traders to conclude that the bank may soon start easing its emergency stimulus measures. Meanwhile, Bank of England Governor Mark Carney conceded there may be a case for an interest rate hike. The comments prompted big rises in the euro and the pound. The euro was up a further 0.3 percent at $1.1415 and near 14-month highs, while the pound rose 0.4 percent to $1.2977. Earlier, the pound breached the $1.30 mark for the first time since last month during the general election campaign.
ANALYST TAKE: “An apparent acceptance by the heads of the U.K. and European central banks that tighter monetary policy may be appropriate in the not too distant future is once again supporting the currencies,” said Craig Erlam, senior market analyst at OANDA. “Comments in recent days appear to suggest they’re reluctantly accepting the growing consensus within their central banks and preparing markets for a potential move.”
SKY RISE: Shares in British broadcaster Sky rose 3.2 percent even though the government referred Twenty-First Century Fox’s takeover bid to competition authorities. Analysts think that the deal, which will see Rupert Murdoch consolidate his media empire, will eventually go through after some concessions are made.
US DATA: Traders will be digesting the final revision to U.S. economic growth in the first quarter, alongside weekly jobless claims. “With investors already doubting whether the Fed will raise rates again this year, it will be interesting to see how they respond should we get a downward revision in the first-quarter figure,” said OANDA’s Erlam.
ASIA’S DAY: Japan’s benchmark Nikkei 225 index rose 0.5 percent to close at 20,220.30 and South Korea’s Kospi advanced 0.6 percent to 2,395.66. Hong Kong’s Hang Seng gained 1.1 percent to 25,965.42 and the Shanghai Composite added 0.5 percent to 3,188.06. Australia’s S&P/ASX 200 climbed 1.1 percent to 5,818.10.
ENERGY: Benchmark New York crude was up 53 cents at $45.27 a barrel while Brent, the international standard, rose 64 cents to $48.18 in London.
Opening up to trade affects long-run growth through several channels. First, trade can affect growth by affecting the return to capital accumulation. Models that analyse the interaction between international trade and economic growth show that, unlike a closed economy, a small open economy can sustain extensive periods of growth with capital accumulation only. If a small open economy adopts policies that foster investment, it can accumulate capital without experiencing falling rates of returns on investments because these are determined in the world market (by factor price equalization) and are unaffected by the investment decision in the small open economy. Ventura (1997) explains in this way the growth of East Asian “tiger” economies in the 1970s and 1980s.
Secondly, trade can affect growth through its effects on the incentive to innovate. In this context, what matters is the effect of trade on market size, competition and knowledge spillovers. Typically, opening up to trade increases the size of the market that a firm faces (scale effect). This increases the reward to R&D because it increases the revenues associated with introducing a new good and, in turn, the incentive to invest in R&D. Therefore, growth increases (Rivera-Batiz and Romer, 1991; Grossman and Helpman, 1991).
Enhanced competition generated by trade has two contrasting effects on the incentive to innovate. On the one hand, competition augments firms’ incentive to invest in R&D. Otherwise, firms are displaced from the market (Peretto, 2003; Aghion et al, 2005). On the other hand, competition lowers the incentive to innovate because it reduces the monopoly rents of the successful innovator. Empirical evidence supports an overall positive relationship between competition and the incentive to innovate, thus supporting an overall positive relationship between trade opening and growth through this channel.
Trade can also affect firms’ incentive to innovate through its effects on knowledge spillovers. Trade can enhance knowledge spillovers because it gives access to the knowledge embodied in the good produced abroad. Trade in transport and communication services may reduce the cost of exchange of information. FDI may contribute to technology transfers through on-the-job training. If discoveries made in a foreign country increase R&D productivity in the home country (knowledge spillovers), domestic firms have a higher incentive to innovate. This will translate into higher growth.
Finally, trade can have positive effects on growth through its effect on the institutional framework. Often trade liberalization goes hand in hand with the adoption of external commitments. Trade liberalization often takes place in a multilateral or regional context. Countries that enter a trade agreement not only commit to lower their trade tariffs but also embrace a certain institutional framework. For example, membership of the WTO also requires countries to comply with certain transparency rules in trade policy as well as certain rules regarding behind-the-border measures, such as technical regulations, subsidies or property rights. Empirical work (Rodrick et al. 2004) supports the idea that international trade improves the institutional framework, and that a commitment to opening up to trade through WTO membership boosts growth (Tang and Wei, 2009).
Overall, the core message of the economic models outlined above is that international trade boosts growth. However, theoretical literature highlights situations where the static gains from trade can come at the cost of lower long-run growth. The main argument here relies on the existence of learning-by-doing in specific sectors and not in others; that is, experience accumulated in a specific sector of the economy drives overall productivity.
Suppose that there are two countries, North and South, and two goods, agriculture and manufacturing. Suppose as well that learning-by-doing only characterizes the manufacturing sector. When these two countries open up to trade, the North will specialize in the production of the manufacturing good and the South in the production of the agricultural good. However, since only the manufacturing sector exhibits a high potential for growth, the North will grow faster under free trade while the opposite will occur in the South.
Two empirical findings reduce the importance of this theoretical argument. First, comparative advantages change over time. All export-led growth success stories have been characterized by a shift of the production structure away from agriculture into manufacturing – for example, Hong Kong (China), the Republic of Korea, Singapore and Chinese Taipei. Secondly, international trade may be associated with knowledge spillovers. Therefore, it is possible – contrary to what is assumed in the model – that knowledge developed in the North transfers to the South.
In developing countries, where domestic innovation is low, international diffusion of knowledge is particularly important for growth. Most importantly, a general result of the economic literature is that even when negative effects of trade on growth exist, provided that there are large knowledge spillovers, the ultimate effect of trade on growth is positive.
 Acemoglu and Ventura (2002) show that long-term growth with capital accumulation only is not sustainable in an open economy (as is typically the case in a closed economy) if countries have market power over the product they export (a high-technology product, for example). This is because, in this case, they will experience a worsening of their terms-of-trade as their exports increase.