Curves and shapes
Following an improvement in competitiveness resulting from the post-referendum fall in the pound, the UK’s trade accounts may now be on the brink of a significant improvement. Even so, continuing and substantial trade and current account deficits suggest that the economy is not yet on a sustainable growth path.
Whilst angst over the longer-term implications of Brexit is still rising, there has also been hope that the depreciation in the pound would have a more immediate beneficial impact on trade flows. The normal focus of attention when the effects of currency changes are debated is on exports; however, a rise in import prices resulting from a fall in the pound should also help companies in domestic markets that are competing with imports. Both effects are mitigated to some extent by the detrimental impact on the production costs of those companies that are using imported raw materials, components and fuels in their production processes. The story is further complicated by differences in the timings of the various effects. So, whereas the impact on the cost of imports of the post-referendum fall in the pound has come through relatively quickly – as would have been expected – the volume benefits from improved competitiveness will become manifest over a longer period. Hence, a change in the value of the currency tends to result in what is called a ‘J-curve’ effect on the size of the trade balance. In this case, the dominating initial impact of the fall in value of the pound is negative, primarily reflecting increased import costs. The positive consequences thereafter, reflecting greater competitiveness of UK companies in both import and export markets are harder to time and to estimate. The supposition is that, eventually, volume benefits will dominate adverse currency effects, but this is not necessarily the case. And the complications to the story do not end here: many companies chose to change pricing behaviour (both in import and export markets), at least in the short term, rather than seek to benefit from, or to mitigate changes in competitiveness.
So, what is the evidence to date? While there is growing evidence that UK companies are beginning to benefit from improved competitiveness, it is harder to determine this in the official data, at least at a headline level, with the trade deficit in the first two quarters of 2017 continuing to average around £9 billion per quarter, a similar level to that seen last year. At the same time, in real terms, net trade made a negative contribution to GDP growth in both the first and second quarters of 2017, seemingly maintaining a longer-term problem. However, digging deeper into the data reveals some slightly more encouraging trends. For instance, the Purchasing Managers Indices for manufacturing have recently shown much higher export order levels than prior to the decline in sterling, and official data for non-oil goods exports are beginning to display good volume growth. That it has yet to show through in the trade balance is because goods imports have also continued to grow quite rapidly and because trade in services has deteriorated.
But the second quarter of this year provided the first evidence of better things to come. I should, of course, give the obligatory health warning about reading too much into short-term trends especially in an area of national statistics in which data is often heavily revised. That said, the three months to June showed a respectable 1.6% rise in export volumes of non-oil manufactured goods, whereas there was a comparable 0.3% drop in imports. It remains to be seen whether this is the start of the journey along the more positive part of the ‘J-curve’ – but I am hopeful.
Overall during 2017, I still expect net trade to make a negative contribution to GDP growth. However, I think there will be a marked contrast between the first and second halves, with growth contributions of -0.8% followed by +0.5%. Taking a broader view of growth, this will help offset the reduced contribution from household spending which, although positive, is clearly less so than previously.
And to end on a final cautious note. The overall current account deficit in 2016 was £84.5 billion, or 4.4% of GDP. Even on very optimistic forecasts, the deficit is likely to remain substantial over the coming years. In very simple terms, whereas the trade deficit measures the difference between what the economy is producing and what is being spent, the current account shows the gap between total spending in the economy and total earnings. To the extent that there is a substantial deficit, this has to be financed by attracting inwards investment, by selling assets overseas or by borrowing overseas. To a certain extent, the first two of these financing methods can be regarded as a peculiar feature of the UK’s business model. However, the extent to which the reliance on capital inflows has become considerably greater in recent years can be seen as the reflection of structural excess demand in the economy – something that remains a fundamental weakness.
Richard Jeffrey was Chief Economist at Cazenove Capital until he retired in January 2018.
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