Maritime Economics

A Macroeconomic Approach

E. Karakitsos, L. Varnavides

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137383419
• Topic: Betriebswirtschaft
• Subtopic: Internationale Wirtschaft

This book analyses shipping markets and their interdependence. This ground-breaking text develops a new macroeconomic approach to maritime economics and provides the reader with a more comprehensive understanding of the way modern shipping markets function.

1 INTRODUCTION

THE SCOPE OF THE BOOK

Following the seminal work of Tinbergen (1931, 1934) and Koopmans (1939) research in maritime economics has focused on integrating the various markets into a dynamic system. This macroeconomic or systems approach to maritime economics reached its heyday with the Beenstock–Vergottis (BV) model (1993). The BV model is the first systematic approach to explain the interaction of the freight, time charter, secondhand, newbuilding and scrap markets under the twin assumptions of rational expectations and market efficiency. The model is a landmark because it treats ships as assets and applies portfolio theory to assess their values. As asset prices depend on expectations, Beenstock and Vergottis introduce rational expectations to account for the impact of expected and unexpected changes in key exogenous variables, such as the demand for shipping services, interest rates and bunker costs.

But since the publication of the BV model, research in maritime economics has shifted from the macro approach to micro aspects. The research has been mainly empirical in nature and has concentrated, for example on the efficiency of individual shipping markets. In one of his many excellent surveys of the maritime economics literature, Glen (2006) concludes as follows:

[t]he models developed and presented in Beenstock and Vergottis (1993) are a high water mark in the application of traditional econometric methods. They remain the most recent published work that develops a complete model of freight rate relations and an integrated model of the ship markets. It is a high water mark because the tide of empirical work has turned and shifted in a new direction. This change has occurred for three reasons: first, the development of new econometric approaches, which have focused on the statistical properties of data; second, the use of different modelling techniques; and third, improvements in data availability have meant a shift away from the use of annual data to that of higher frequency, i.e. quarterly or monthly. (Glen 2006, p. 433)

This book aims to fill this gap and make a return to a macroeconomic or systems approach to maritime economics. The brilliant book by Stopford (2009) is in the same spirit and covers all markets and their interaction at an introductory level. This book aims to be a companion to Stopford’s textbook at a more advanced level.

1 THE BENEFITS OF A MACROECONOMIC APPROACH

A macroeconomic approach to maritime economics offers a number of advantages. The first relates to the microfoundations of the freight market and the second to the microfoundations of the shipyard and secondhand markets. In the traditional approach, which goes back to the Tinbergen–Koopmans (TK) model, freight rates are viewed as determined in perfectly competitive markets, where the stock of fleet is predetermined at any point in time. This implies that freight rates adjust instantly to clear the demand–supply balance, where supply is fixed (subject only to a variable fleet speed). Accordingly, freight rates respond almost exclusively to fluctuations in demand, rising when demand increases and falling when demand falls. The assumption that supply is fixed even in the short run is not appropriate, as supply is constantly changing. Charterers and owners observe the evolution of supply and must surely form expectations of future demand and supply in bargaining over the current freight rate. This calls for a dynamic rather then a static analysis in which the fleet is fixed. In Chapter 2 we suggest an alternative theorising of the freight market, which captures this dynamic analysis of freight rates. This new framework consists of a bargaining game over freight rates in which charterers and owners form expectations of demand and supply over a horizon relevant to their decisions. In this approach, freight rates are viewed as asset prices, which are determined by discounting future economic fundamentals.

This macroeconomic approach to freight rates is appropriate to recent macroeconomic developments. The business cycles of the major industrialised countries have shifted from demand-led in the 1950s and 1960s to supply-led in the 1970s and the 1980s and, finally, to asset-led cycles over the past twenty years, driven by excess liquidity. The liquidity that has financed a series of bubbles, including the Internet, housing, commodities and shipping bubbles, during this period was created as a result of a gradual process. Financial deregulation and liberalisation laid the foundations for financial engineering, while central banks have pumped more liquidity into the financial system every time a bubble has burst, thereby perpetuating the bubble era. The expanding liquidity has resulted in the financialisation of shipping markets, a topic that is analysed in Chapter 8. In the first phase of financialisation the liquidity affected commodity prices, including those of oil, iron ore and coal. The advent of investors in the commodity markets increased volatility in freight rates and vessel prices and distorted the price mechanism. Prices convey a signal of market conditions. The advent of investors in commodity markets pushed prices higher than was justified by economic fundamentals in the upswing of the cycle and lower in the downswing, thereby increasing the amplitude of the last super shipping cycle. In the second phase of financialisation, which is taking place now, the financialisation of shipping markets is affecting vessel prices turning ships into commodities. The financialisation of shipping markets makes the bargaining approach to freight rates a more plausible framework.

The second advantage of a macroeconomic approach to maritime economics relates to the microfoundations of the shipyard market, where the Beenstock–Vergottis approach remains a valid model within a macroeconomic framework. The BV model suffers from a major drawback, which has gone mainly unnoticed and unchallenged in the maritime economics literature in the last twenty years. This is that the microfoundations of the BV model involve decisions intended to maximise short-term profits (that is, profits in every single period of time) instead of maximising long-term profits (that is, profits over the entire life of the vessel). Short-term profit maximisation is imposed either explicitly as in the freight market or implicitly by invoking market efficiency, as in the secondhand and newbuilding markets. The combination of short-term profit maximisation and market efficiency destroys the simultaneity of the BV model. Decisions in the four shipping markets (freight, secondhand, newbuilding and scrap) are not jointly determined. The decisions can be arranged in such a way so that one follows from the other. This has serious implications for fleet expansion strategies, as it makes them oversimplistic. The fleet capacity expansion problem is analysed in Chapter 3 and the interaction of business and shipping cycles, is investigated in Chapters 6 and 9.

To illustrate the oversimplistic nature of the BV framework, consider an owner that maximises profits in each period of time, say a month, by choosing both the average fleet speed and the size of the fleet, so as to equate the return on shipping, adjusted for a variable risk premium, with the return on other competing assets, such as the short- or long-term interest rate. The fleet is adjusted monthly to reach the optimum via the secondhand and scrap markets. An owner adjusts his actual to the optimal fleet on a monthly basis by buying or selling vessels in the secondhand market or scrapping existing vessels according to the principle of monthly profit maximisation. Thus, an owner in the BV framework may expand the fleet one month and contract it the next month. In general, unanticipated random fluctuations in any exogenous variables, such as the demand for shipping services, interest rates and bunker costs, would trigger oscillations in the owners’ fleet. Therefore, the owner in the BV model is myopic in that s/he ignores the consequences of her/his actions today for the lifetime of the vessel despite forming rational expectations. These two unsatisfactory features of the BV model of market efficiency and short-term profit maximisation are corrected in this book. In Chapter 3 it is shown that the appropriate framework for fleet expansion strategies is long-term profit maximisation. In Chapter 4 it is shown that the empirical evidence on the whole suggests that shipping markets are inefficient for practical purposes in decision making, although shipping markets may be asymptotically efficient (that is, as the investment horizon tends to infinity). The integrated model, which is laid out step by step in the preceding chapters, is analysed in Chapter 6 in an attempt to explain shipping cycles.

A macroeconomic approach also has the advantage of integrating the supply and expectations approaches to shipping cycles. The TK and BV model have shaped the theory of shipping cycles. The contribution of the TK model is that the basic cause of shipping cycles is the shipyard delivery lag. Thus, in the TK model shipping cycles arise naturally, even if demand is stable, because of the lag between placing orders and the ability of shipyards to deliver. The BV model emphasises the adjustment of expectations to exogenous shocks as the primary cause of shipping cycles. The macroeconomic approach developed in this book integrates the TK model of supply-led shipping cycles with the BV model of expectations-driven shipping cycles. As the empirical evidence of shipping markets shows that they are inefficient in the short run, the integrated model breaks away from the BV model of assuming that shipping markets are efficient. The implication is that the arbitrage conditions between newbuilding and secondhand prices and between the return of shipping and alternative assets are removed. Instead, demand and supply factors in newbuilding and secondhand markets are allowed to interact in determining prices. This has the implication that all shipping markets interact with each other. As a result, a fleet capacity expansion strategy involves expectations of future freight rates, newbuilding, secondhand and scrap prices and the net fleet, which are jointly determined. This makes fleet expansion strategies a complicated task.

The integrated model also includes the business cycle model developed in Chapter 5. In the BV model expectations are rational and drive the dynamics of the shipping model, along with the fleet accumulation dynamics, but the demand for dry is exogenous to the model. In the integrated model the demand for dry is endogenous. The implication of extending the model to cover the interaction of business and shipping cycles does not simply provide a more realistic explanation. It is shown in Chapter 6 that expectations about future freight rates, vessel prices and the demand supply balance (fleet capacity utilisation) are shaped by expectations of the future path of real interest rates and consequently on monetary policy; and, in particular, on how central banks react to economic conditions. As central banks choose their policies with the view of achieving their statutory targets, by observing current inflation and the output gap and knowing the central bank’s targets, one can deduce the future path of nominal interest rates. This provides a consistent explanation of how expectations in shipping are formed integrating macroeconomics with maritime economics. This interaction is analysed in Chapter 6.

2 THE STRUCTURE OF THE BOOK

Part I deals with the microfoundations of maritime economics, which attempt to derive the general form of the underlying demand and supply functions in all four markets (freight, spot and period, newbuilding, secondhand and scrap) based on the principles of rationality, which is the basis of a scientific approach to maritime economics. Economic agents in shipping markets are assumed to be utility or profit maximisers, subject to well-defined economic and technological constraints. Chapter 2 analyses the microfoundations of the freight market (spot and period), while Chapter 3 the microfoundations of the other three markets.

Part II analyses the macro aspects of maritime economics. Chapter 4 reviews the empirical evidence of whether shipping markets are efficient and concludes that they are inefficient in a horizon relevant to decision making, although markets may be asymptotically efficient. Chapters 5 and 6 provide a macro-economic approach to maritime economics by examining all four shipping markets as a system of simultaneous equations. In Chapter 5 the model is extended to include the macroeconomy and explain how business cycles are generated using the New Consensus Macroeconomics model, as modified by Arestis and Karakitsos (2013).

Chapter 6 integrates the work from all the previous chapters. It studies the interactions of all four shipping markets and how they respond to anticipated and unanticipated shocks giving rise to shipping cycles. It investigates the causal relationship between business and shipping cycles. The analysis shows that shipping cycles are caused by business cycles. The TK model is instructive of the implications of the delivery lag. Depending on parameter values, shipping cycles can appear out of phase with business cycles, thereby giving the impression that shipping cycles move counter-cyclically to business cycles (that is, they move in opposite directions). But such behaviour does not change the direction of causality. Business cycles cause shipping cycles. Finally, Chapter 6 shows how expectations about key shipping variables can be formed consistently by expectations on economic policy (interest rates). In particular, it is shown that inflation depends on the expected path of the future output gap (the deviation of real GDP from potential output). The output gap in the economy, in turn, is a function of the expected path of future real interest rates. Central banks affect real interest rates by controlling nominal interest rates. Therefore, both inflation and the output gap are functions of the expected path of future real interest rates, which are influenced by monetary policy. Expectations of future freight rates and vessel prices depend on the expected future path of fleet capacity utilisation, the demand–supply balance in the freight market. Given a shipyard delivery lag of two years, the supply of shipping services is largely predetermined by past expectations of current demand for shipping services. Demand depends on expectations of the future output gap, and, consequently, on monetary policy. Therefore, by observing current inflation and the output gap and knowing the central bank’s targets one can deduce the expected future path of key shipping variables. This illustrates the interaction of the macro-economy with shipping markets providing an integrated model.

Part III takes the big step of moving from theory to practice. Chapter 7 explains the market structure and the role and impact of ship finance. Chapter 8 explains the financialisation of shipping. The nature of the shipping markets has changed from a fundamental transport industry into an assets (or securities) market. Freight rates and vessel prices are determined as if the shipping market was a stock exchange one. This structural change occurred simultaneously in the dry and the wet market in 2003, as a result of the attraction of investors into commodities. Speculative flows into commodities distorted freight rates and vessel prices by creating a premium/discount over the price consistent with economic fundamentals (demand and supply). There was a premium in 2003–11, turning a boom into a bubble, but a discount since 2011 adding to the gloom during the depressed markets of 2011–13. The implication of this structural change is that the outlook for the dry and wet markets depends not only on economic fundamentals, but also on the risk appetite of investors.

Chapter 9 analyses the interrelationship of business and shipping cycles in practice. It describes the stylised facts of shipping cycles. It analyses the official classification of business cycles, using the US as an example because of its possible impact on world cycles, and puts forward an alternative approach that enables the distinction between ‘signal’ and ‘noise’ in identifying trends and discerning the reversal of trends. This approach helps to compare the actual and optimal conduct of US monetary policy in business cycles and shows how relatively accurate expectations of interest rates can be formulated in shipping. Chapter 9 analyses the business cycles of Japan and Germany and their interrelationship with US business cycles and shows how these business cycles account for the stylised facts of shipping cycles in the 1980s and the 1990s. The cycles since then are explained by the behaviour of China, which has supplanted Japan in pre-eminence in world trade. Although China is now the factory of the world economy, thereby explaining the long-term growth rate of demand for shipping services, the trigger for the fluctuations in demand has been the US because of its importance in shaping world business cycles. This was true in the 1980s and the 1990s, when Japan was explaining shipping cycles and it has remained true ever since because China is an export-led economy. It will take time for China to reform its economy from an export-led to a domestic-led one, a reform that has been endorsed at the Third Plenum of the party in November 2013.

Although shipping cycles are generated by business cycles, in the real world they are also caused by large swings in expectations of demand for shipping services. Volatile expectations can be rational, as a result of cyclical developments in macroeconomic variables, or irrational, what Keynes (1936) called ‘animal spirits’, a situation where economic fundamentals remain unchanged and yet expectations swing from optimism to pessimism. This swing of expectations is related to uncertainty about macroeconomic developments. Therefore, a full explanation of the stylised facts of shipping cycles requires an extension of the business cycle analysis to conditions of uncertainty and the role of the availability of credit (ship finance). The theory of the fleet capacity expansion under uncertainty, analysed in Chapter 3, provides the basis for this extension. Chapter 9 explains how uncertainty about demand can lead to overcapacity, as owners may decide to wait until the recovery is sustainable before investing.

The availability of credit makes shipping cycles even more pronounced than otherwise. Banks and other credit providers are highly pro-cyclical; the loan portfolio increases in the upswing of the cycle and decreases in the downswing. This is due to the myopic attitude of credit institutions in granting credit according to the collateral value of the loan, which is highly pro-cyclical. Therefore, ship finance increases the amplitude of shipping cycles.

In every severe recession the pessimist view that shipping would never recover gains ground. This is based on the well-known conspiracy theory that it is in the interest of the country that depends most on world trade, such as Japan in the last twenty years of the twentieth century or China in the present day, to increase the fleet to keep freight rates low. Chapter 9 deals with this issue.

Instead of summarising the macroeconomic approach to maritime economics, the final chapter provides two practical examples of the approach advanced in this book. First, it shows why the majority of owners with experience can be relatively accurate in buying ships and expanding their fleet, but also that with a few exceptions they are bad decision makers in selling ships and taking profits...