Bank of England cautious over weak pound’s likely boost to trade

Posted on November 11, 2016

The Bank of England has cast doubt on the idea that the weak pound will lead to a boom in exports, warning that companies will not invest until they know the country’s future terms of trade following the Brexit vote.

Sterling has lost a fifth of its value on a trade-weighted basis during the past year and a similar depreciation when the UK left the European exchange rate mechanism in 1992 provided a significant boost to net trade.

But opinion is divided over whether this year’s fall in the pound will see exports rise and imports fall, as domestic consumers buy British instead. Some economists point to the aftermath of the financial crisis for proof that UK trade flows are insensitive to the value of sterling.

“If devaluation was the great success factor for the UK economy, we should be the most successful economy on earth,” said Andrew Sentance, senior economic adviser at PwC and a former member of the Bank of England’s Monetary Policy Committee, pointing to the fact that the pound was worth $5 before the second world war but has depreciated steadily and significantly since, now trading at about $1.24.

The bank’s current forecast is for exports to grow by 2 per cent in 2017 and 1 per cent in 2018, while imports will increase by 0.25 per cent in 2017 and then shrink by 1 per cent in 2018.

But it noted in its latest inflation report that some manufacturers “are particularly integrated into EU supply chains” and that sectors such as financial services would be “sensitive to any changes in trading arrangements”.

It said: “The depreciation in sterling of 21 per cent over the past year should support UK exports and weigh on imports over coming years. But … there is uncertainty over the magnitude of these effects, and net trade … will be sensitive to how companies anticipate and respond to possible future changes in the United Kingdom’s trading arrangements.”

The UK has become increasingly integrated into global supply chains, with many goods produced using foreign components, which have become more expensive because of sterling weakness.

Over time there ought to be an incentive for UK companies to look for domestic suppliers instead. But businesses may not be well-placed to step up: the economy has become increasingly specialised in producing high value-added goods and services.

There is also evidence that demand for UK exports is insensitive to price. The UK is more reliant than many other countries on exporting services, rather than goods.

Demand for services seems to be less sensitive to price changes than demand for exported goods and the Office for Budget Responsibility estimates a 10 per cent fall in the relative price of exported services will increase demand by just 2.2 per cent.

“If a fall in the pound leads to a significant rise in exports, you’d expect to see [UK exports relative to world trade] rise after sterling’s fall in 2008-09,” said Chris Dillow, an economics commentator. “But it’s hard to discern any such significant move.”

But it is also possible 2008 was an exception rather than a new rule. The years after 2008 saw very weak growth among the UK’s major trading partners, limiting the potential for export growth and the global financial crisis was a profound shock for one of Britain’s biggest exports: financial services.

If UK exporters are able to “price to market” and leave the foreign currency price of their goods unchanged, they could also receive a bonus in sterling terms. “Those extra revenues will provide firms with the resources to pay higher dividends and wages and/or increase investment,” said Martin Beck of Oxford Economics.

Meanwhile, the demand in the UK for imported services is extremely sensitive to price. One example of these “imported services” is holidays abroad. The weaker pound will encourage “staycations” — the British tourism industry is well positioned to step in as a substitute for holidays farther afield.

But boosting net trade significantly will require companies to make investments — to ramp up production of exportable goods and services and to reposition themselves as producers of currently imported items. Uncertainty on the UK’s future domestic policies, trading relationships and the value of sterling could discourage them from doing so. Business surveys hint this is the case.

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