Thursday, 13 October 2016

The currency effects of Brexit

Sterling is falling. Predictably, the financial press describe its slide as a "pounding" and gleefully tell us that sterling is the worst-performing currency after the Argentinian peso.

But some people are cheering. Falling sterling is good for exports, isn't it? So if the pound keeps falling, the UK's large trade deficit will start to shrink, reducing the UK's dependence on external financing and hence its vulnerability to a "sudden stop".

Sadly, it's not that simple. Falling sterling is not an unalloyed good for exporters. The real effect is considerably more nuanced, and over the longer term, not necessarily positive.

As an exporter myself, I am certainly enjoying the pound's fall. These days, most of my income is in US dollars. This is how GBRUSD has performed this year:


Since my income is in dollars but my outgoings are in sterling, I've had a pretty substantial pay rise.

But my chickens will come home to roost shortly. The price of petrol is about to rise by 5p a litre because of sterling's fall. That is a real cost which I cannot avoid, since my singing teaching requires use of a car. My income is still rising, but my profits will be diminished by rising costs. When the fall in sterling affects other business costs too, such as air fares, train fares, hotels and subsistence, I might be looking at a rather substantial rise in my costs.

Business costs are already rising for exporters whose business inputs are raw materials and intermediate goods. And all of us face higher energy and transport costs, because the UK is dependent on imports of oil and natural gas, and those are priced in dollars and euros.

This chart from Reuters shows that producer price inflation is already rising fast:


The net gain for exporters is still positive, but energy price rises have yet to bite. Exactly how much of the income improvement due to currency effects will be wiped out by rising input costs remains to be seen. For some exporters - especially in the UK's fragile manufacturing sector - it could even be a wash.

And that is before we get to the effect of inflation on labour costs. I face rising prices for food, clothes and other consumer goods. As a sole trader, my profits are my income, so I will shortly face a reduction in my disposable income as inflation eats into my profits. But businesses with employees are likely to face demands for wage increases. The businesses most affected will be those that have skill shortages, powerful unions and/or need seasonal labour that could now be hard to come by, because the weak pound makes temporary migration from overseas less attractive.

The fact is that the UK is an import-dependent economy, and sterling's fall makes imports more expensive. For businesses, this means higher costs. For households, this means lower living standards, at least in the short term. As Paul Krugman says, sterling's depreciation makes Britain poorer.

Over the longer term, we might find that higher import prices encourage the growth of domestic industries producing goods and services that can substitute for expensive imports. But there are two obstacles to this.

The first is the UK's dependence on imports for energy. High energy prices due to sterling's weakness will put downward pressure on domestic demand, simply because people will prioritise heating, lighting and fuel over consumables. We've seen this before: high oil prices in 2010-13 were a major reason for the failure of the UK's recovery after the financial crisis. There is no reason to suppose that this time would be different.

The same energy price constraint bites on domestic businesses, which would face higher costs than their overseas competitors. Given this, would they really be able to undercut importers by enough to generate widespread substitution effects - especially if, after a hard Brexit, the Government decided to cut import tariffs unilaterally, as some have suggested?

We need substantial investment in replacement energy sources as North Sea Oil dries up. The UK has neglected this investment over many years now, and it is about to pay the price for this folly. Replacement energy sources take quite some time to come on stream, and during that time the UK will face higher energy prices and associated inflation, to the detriment of households, businesses and the economy as a whole.

The second obstacle is inward investment. The UK has historically been a favourite destination for foreign investors, attracting more capital investment than anywhere else in Europe. This is no doubt due to its dominant financial sector, deep and liquid capital markets, and enormous supply of investment assets. Being a favoured investment destination is of course, something of a double-edged sword: the UK's yawning current account deficit is to a considerable extent due to its attractiveness to foreign capital (the capital account is the mirror image of the current account, so a capital account surplus is matched by a current account deficit). But if the UK is to develop new domestic and export businesses, it will need inward investment.

Some people seem to think that the current starry performance of the FTSE 100 indicates that inward investment into the UK is holding up. Sadly, this is not true. The falling currency is a clear sign that investment is leaving the UK, as are rising yields on gilts. At present, all the signs are that investors are becoming exceedingly wary of investing in the UK.

All of this leads me to conclude that those who think a falling pound will somehow bring about radical rebalancing of the economy away from financial services and towards revitalisation of manufacturing are taking far too simplistic a view. The UK economy is highly financialised and largely consists of service industries. Manufacturing is still about 14% of the economy, but the heavy manufacturing of the past is gone: UK manufacturing now is specialised, highly skilled and makes extensive use of imports. Even were foreign investment to hold up, it would take a very long time for the UK to expand manufacturing to the level of say Germany. It's worth remembering that a 25% devaluation in 2008-9 made little significant difference to manufacturing production or goods exports. As I said above, why would this time be different?

Sterling's fall should be regarded as at most a short-term monetary stimulus to the economy. The UK now has the loosest monetary policy in the G7 (eat your heart out, Kuroda-san!). This is in large measure the reason for the apparent calm in the UK economy, along with buoyant consumer confidence (which is no surprise, since the great British public apparently believe that leaving the EU and restricting immigration will make them more prosperous). It creates a breathing space in which the Government can devise a sensible approach to leaving the EU. But if it is to foster lasting change, it must be partnered with a radical fiscal response involving substantial infrastructure investment, a properly funded business bank and a realistic industrial strategy. Without these, sterling's fall will simply herald the dawning of a poorer, meaner future for Britain.

Related reading:

Brexit is making Britons poorer and meaner - The Economist
UK's trade-weighted currency index slumps to historic new low on hard Brexit fears - The Independent
Brexit and Britain's Dutch disease - FT Alphaville


30 comments:

  1. Great Article! You might have added a few things things, I'll be brief (and somewhat clumsy) since I am on mobile:

    First, Russia suffered a shock since 2014 when oil crashed;this was on top of a decline in investment and the economy since Putin started nationalising things around 2012 or so.

    In the UK's case the currency crash is already happening since investors can anticipate the decline in the pound. But the actual reduction in export revenues nor any potential decline in productivity or increase in the state sector hasn't happened yet. So there is much more pain to come.

    Second, you will likely see an increase in political instability going forward as the depreciation starts to make itself felt. This will drive away even more investors. The "people's power" could be the thin end of the wedge, like the start of the French Revolution.

    Third, the UK's food dependence guarantees trouble. The UK will not be able to impose tariffs on food or otherwise dissuade foreign countries from selling into the British market IMHO unless it wants to end up like Russia. Since Moscow has imposed "counter-sanctions" on foreign produce, combined with the depreciation in the ruble, Russians now spend half their income on food.

    So the UK will not be able to prevent the EU from just dumping its surplus production on Britain without British farmers getting reciprocal rights. It would suit the EU to wreck the UK's agriculture in any case to prevent competition and for geopolitical reasons. The alternative is for the UK to risk food riots it seems when combined with a weak pound. So this will weaken the UK's hand during the Article 50 negotiations.

    Fourth, a weaker currency means that the UK's geopolitical weight is smaller, which makes trade deals harder to get. A smaller economy can't afford to open as many diplomatic missions abroad either.

    In particular, the military will be hurt by an inability to buy expensive equipment and components from abroad, so their means less F-35s or noise reducing components for submarines and the such. This will be embarrassing when the cuts are announced. The UK is a merchantile sea power, not a frugal land power like Russia; I'm not sure it will cope with these changes circumstances well

    The cumulative effect will be to make the UK less useful to the US, so Washington will be less inclined to do favours for London, or turn a blind eye to things like shady tax schemes in the City. This will diminish the pound further,

    Fifth, I'm not sure how the UK could break out of a wage-price spiral with stagflation in this political climate. Thatcherite tactics would just make more trouble. This will cause inflation to increase even more.

    I am seeing hints of Latin-American style populism that will be very hard to get away from if it gets into the UK's political system. It could be considered a bad political equilibrium.

    Sixth, as the pound gets weaker and more volatile, an independent Scottish currency will be more viable. A country at risk of breaking up will find it harder to attract investment and will be more unstable.

    Seventh, All of these factors are mutually reinforcing to some degree. Most people seem to expect
    pound-euro parity to be sufficient to balance out the current account deficit. But taking all of the above into account, the true equilibrium will be lower, I'm not sure by how much though.

    Finally, Ireland and the punt might give an idea for the future of the UK going forward, the Irish Central Bank was always paranoid about inflation.

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    1. I might rephrase part of that post actually since it was potentially unclear.

      Instead of thinking of modelling the rate of the pound, or even modelling the British economy, think in terms of modelling the UK as a holistic entity.

      The UK as an entity roughly consists of several "systems" : the political , the economic, the military, the diplomatic and so on. In this case the monetary system could be viewed as a subset of the economic system.Obviously all of these various parts interact with each other.

      A sufficiently severe shock in one system can propagate to the other ones and influence them. The first order effect can then spread out again in turn and so on and so on until a new stable point is reached.

      A currency crash will weaken the UK politically and militarily. But the weakness there can feed back into the economy. This in turn means a weaker currency which will weaken the UK further.

      In the meantime the political system is becoming less effective: Scotland is considering seceding. Politicians call for price controls and complain that the Bank of England should be serving the people instead of fatcat bankers.

      London finds it harder to get the ear of Washington, which diminishes its influence in Europe further. As a result, EU policy tends to be more anti-British which harms the UK's economy and causes more political instability.

      I could continue adding in more factors, but I think people get the point.

      The breakup of the Soviet Union, which was precipitated by an oil price crash, shows how far this could go. The UK in 5-10 years time will likely be weaker in every dimension and not just in macroeconomic terms, as a result any long term forecasts of the state of the British economy based on economic models alone are likely to be too optimistic.

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  2. Seems like British economists forgot the external conditions of the UK in the post-war period. And even then, the UK had a larger manufacturing sector than nowadays. Import restrictions and exchange controls were the norm, am I wrong? Devaluations weren't much of a help even at that time. This is my main disagreement with MMT people who believe that floating your currency solves the balance-of-payments constraint. You had a good post on this before.

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  3. Perhaps you were saying this, Frances, but it doesn't feel apt to describe the UK's unusually high historical inward FDI as good "performance". I appreciate the capital and current account are both endogenously determined, but it seems much more likely that the FDI was driven by strong imports than that the foreign demand for FDI pushed the UK to a large current account deficit.

    As I see it, the main component of inward FDI which is surged is retained earnings at the UK affiliates of international corporations.

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    1. I really don't agree. Imports do not drive the demand for London property, nor for sterling-denominated financial assets sold worldwide. The UK's economy is financialised and it hosts the world's premier financial centre. That, not imports, is what drives the UK's current account deficit - just as the US's current account deficit is driven by global demand for US dollars and US treasuries.

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  4. The last three UK Article IV annual reports from the IMF indicated overvaluation of Sterling estimated at 12%-18% in the latest report. With a current account deficit reaching 7% of GDP the “kindness of strangers” has, perhaps, reached its limits.

    https://www.imf.org/external/pubs/ft/scr/2016/cr16168.pdf

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    1. Please don't read too much into the current account deficit. The trade deficit is much smaller and very stable. The big increase in the last couple of years is because of divergence of returns on sterling and Euro assets, which is mainly due to ECB monetary policy.

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    2. I think the contrast to Brexit inspired depreciation and current account inspired depreciation is well founded. Maybe, Brexit was the final straw but the trade weighted index has been trending down for a while. The BoE underground blog has a good piece.

      https://bankunderground.co.uk/2016/10/13/double-trouble-how-closely-related-are-the-uks-twin-deficits-and-should-we-be-concerned/

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    3. Very sorry, Mike, but Dork of Cork is banned from commenting here, so I've deleted his post.

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  5. I am in the opposite situation to you: earnings in pounds but costs in dollars; so e.g. a 2kg bag of sugar is now 1.66 and before 1.42, approximately. But still a leaver. If UK businesses as these fine folks suggest are partly just using the depreciation as a cover to increase their sterling prices then that will gradually come into the spotlight: no increase in output etc. Marmite should be going through an export boom as a wholly UK made product without any currency depreciation import inflation costs yet they are raising their UK prices. If they have raised their export sterling price then it is clear that they are just profiteering at the expense of UK output.
    http://www.oxfordeconomics.com/my-oxford/publications/345652

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    1. You seem to be suggesting that Unilever was taking advantage of the sterling fall to force through an unwarranted price rise on a product on which its costs had not risen.

      I'm afraid I disagree. Unilever produces its accounts in Euros, so it faces translation losses on all sales in sterling, regardless of where the product is produced. So although Marmite is produced entirely in the UK, Unilever would still want to raise the sterling price if sterling fell versus the Euro. In fact, although it caught the attention of the UK media because it is an archetypal British product, Marmite was far from being the only product affected. Unilever wanted to raise prices across the board.

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    2. Why is Unilever trying the same thing with some Irish supermarkets?

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  6. Frances, yours is more or less the line taken by Eichengreen as well. https://www.project-syndicate.org/commentary/small-uk-export-boost-since-brexit-vote-by-barry-eichengreen-2016-09
    Although I don't quite understand what the fuss is about. That Brexit is a shock is clear, capital flows are reversing. Would it have happened anyway at some point in the future given the high CA deficit? Maybe but who cares. Now the point is: the UK with a floating currency can implement countercyclical policies (fiscal and monetary) to respond to the shock. The ball is in the government side now.
    It should be stressed though that if UK had a peg (or had joined the Euro) the impact of the capital flight would have had pro-cyclical effects with much much worse consequences on output and employment.
    In the end, crises happen, whether triggered by political decisions or by changes in investors' mood. The UK has the tools to respond, unlike some of its EU partners. Let's hope they use the tools well now.

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    1. Mirco, I completely agree. If the UK were in a fixed exchange rate system the policy options open to it would be far more restricted and it would be at serious risk of a "sudden stop". Because it has an independent and well-respected central bank, and control of monetary policy due to the floating exchange rate, it can buffer the productive economy to a considerable extent. With supportive fiscal policy, we should be able to ride out this short-term storm reasonably well.

      That said, however, the Bank of England can't do everything. Falling sterling does mean inflation in essential goods, particularly oil, gas, foodstuffs and raw materials. This means firstly that businesses will face higher costs, which will squeeze their profits if they are not exporters. Only 11% of UK businesses are exporters, so that means MOST UK businesses will face higher costs. This is bound to have negative consequences for wages and employment. On top of this, households face higher domestic bills. So real incomes will be squeezed from two directions. The Bank of England could raise interest rates to prevent inflation rising too much, but at the moment the Governor is signalling that monetary policy will remain loose. This is probably wise: raising interest rates into a short-term supply shock is not good policy unless inflation is really spiralling badly, which at the moment it is not. It is widely thought that the ECB raising interest rates in the 2011 oil price shock triggered the Eurozone crisis. The Bank of England won't have forgotten that.

      Longer-term, recovering from what will be quite a nasty supply-side shock will require fiscal, not monetary, policy.

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  7. Back to coal then as the indigenous energy source?

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    1. Not coal but new very efficient combined cycle gas power stations. Natural gas import prices are at a "[...]current level of 4.21 (MMBtu), down from 4.47 last month and down from 6.71 one year ago. This is a change of -5.82% from last month and -37.26% from one year ago". It is a pity that these price reductions are not fully passed on to consumers in our dysfunctional energy markets.

      https://ycharts.com/indicators/europe_natural_gas_price

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    2. Interesting. Why can't these new systems be stuck on top of fracking ng wells, not literally, but very local to the well.

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    3. Horizontal fracking too new to understand lifespan of a single well. Many small gas plants, e.g. one per site, would be uneconomic. Also, the opposition to fracking might be overcome by the small footprint of well site. But a 200MW plant with electricity pylons to the grid would be hard to disguise with a few trees. And, it is doubtful that a single field could keep such a plant running so build near additional supply points.

      BTW - cheaper energy equals cheaper Marmite.

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    4. https://www.gov.uk/government/news/chancellor-unveils-infrastructure-body-to-help-build-better-britain-for-everyone
      Admirable reply. You can make a valuable contribution to the specific requests asked for by the new infrastructure commission. It does cover energy production.

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    5. UK fracking due to start early 2017 and Ineos already importing cheap US shale gas via Grangemouth. I suspect Ineos is considering building/buying CC gas plants once it has secured sufficient [cheap] gas supply.

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    6. Can they not be persuaded to do some crude refining too: jet a1 and diesel with chemicals in completely modern plants.

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  8. The long term success of the UK economy has been chronically neglected by successive governments for decades. It is now in permanent decline heading towards third world status.

    The "point scoring" adversarial political system is unable to establish and support longterm multidecade policies to bring the economy out of the mess.

    Built upon an empire, essentially theft from other nations, the uk has since done almost nothing to remain globally competitive. All the hubris has to be knocked out of the island and the stark reality that the uk is now an insignificant and unattractive place to do business must be faced.

    India is the largest industrial employer, China is to build a nuclear power station, France is to supply steel for submarines. Britain has entirely lost the plot, seemingly an economy based on rising house prices and a parastic financial industry.

    Inward investment? Oh dear, another symptom of third world status. If the uk had an economy then the uk would be making investments abroad, not expecting developing countries to invest in the uk. Which they will no longer be doing, as the gateway to Europe is now closing.

    There is no hope. The uk has become a nation of property speculators and benefit collectors run by a bunch of self-serving incompetent politicians.

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    1. You seem to hit the nail on the head, good and hard.

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  9. Maybe somebody has already made this point - in which case, apologies - but we keep hearing about serious skill shortages in the UK (which of course is one very good reason why we need well-qualified immigrants). But improving the skills levels of the existing population is much easier said than done, and successive governments have been trying, and failing to correct this problem for decades now. My point is that while it may be a "good thing" in the long run to move away from an unbalanced, finance-based economy, we won't be able to do this without a radical improvement in skills. And it could take a generation, IF it ever succeeds. Our comparative advantage in finance has developed over two or three centuries. You can't just wave a magic wand and turn the UK into....Germany.

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  10. "But improving the skills levels of the existing population is much easier said than done, "
    We did do this rather well during WW2.
    How many UK citizens could pilot a four-engine plane, service a radar installation, or even drive an HGV, in 1939?
    Mind you, I suspect this was accomplished without input from even one Professor of Education.

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  11. The GB Pound exchange rate seems to be following a linear downward trend that was going on before Brexit.

    In graph #1, if you drew a strait line from the 1st data point to the last you roughly get a linear interpolation (line) fit. The divergence seems to be three months before Brexit when the pound exchange value was rising above the linear line. Then you get reversion to the line with an temporary overshoot after the vote.

    Thus, it might not be the fault of Brexit, as the fall started earlier.

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    1. No way. The sudden fall in sterling in June is very clear, and even more evident on the GBPEUR chart in my latest post. Also, a chart going back further would show sterling falling from the beginning of the year. News reports throughout this time clearly show the fall was due to Brexit uncertainty.

      An interesting attempt to rewrite history,but I'm not convinced.

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    2. "News reports throughout this time clearly show the fall was due to Brexit uncertainty."

      So, that explains more than year drop.

      Thank you. I stand corrected for analyzing from a foreign country such little information as a graph of two variables. (GBPUSD exchange rate and time.)

      After doing some research, it looks as if the referendum was known before it's announcement in February of 2016. As, and in out referendum was a campane promise by Mr. Cameron who was elected prime minister in May 2015. And, there must have been discussions and news before as you mentioned.

      My speculative interpretation was not intended to rewrite history. I should have framed it as a question.

      So, are the folks in the financial markets acting that far ahead, before referendum announcements?

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  12. Falling sterling might be an indicator with a problem with the desirability of British exports compared to imports. I don't know how to fit this in with purely merchant traders.



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