Has the pound’s devaluation helped stimulate the economy?

Over the last year, the pound has lost 20% of its trade-weighted value and further falls once Article 50 has been activated and beyond look likely. The negative effects of the weaker pound are becoming increasingly apparent – imported items like petrol, food and electrical goods will rise in price, as recent announcements by Unilever and Apple have demonstrated. Firms that import raw materials from abroad have seen their input costs sharply rise, and face either passing on these costs to the consumers or see their profit margins reduced. It is this which is expected to drive inflation to around 3.5% in early 2018 despite weak wage growth, meaning real wages are set to fall. Indeed, this is certainly an influential factor in the report by the IFS, which states that real wages in 2021 are expected to be less than they were in 2008.

But a weaker pound has benefits cry the Brexiteers, for it will boost exports. Goods produced in the UK suddenly become cheaper abroad, and the increased demand from overseas will stimulate economic activity and increase jobs. The UK’s balance of trade has been in deficit for the past 15 years, and the depreciation will force us to stop relying on cheap imports and start looking for domestic producers within the UK. Sure, your holidays abroad might be slightly more expensive, but a weak pound results in an influx of tourists visiting the UK and will provide a boost to the UK’s leisure and tourism sector.

Yet the Bank of England has expressed clear doubts towards the idea that the depreciated pound will have a particularly significant effect on exports anytime soon. This is shown by the fact that the UK’s trade deficit only narrowed slightly in the third quarter of 2016 and actually widened by £1.6 bn in September. In addition, export growth predictions of 2% in 2017 and by 1% in 2018 are underwhelming, which perhaps explains why Phillip Hammond has opted to double the resources for the UK Export Finance department in the Autumn Statement. However, the Bank of England also predicts that the current account deficit will nearly half over the next three years. It seems then that the expected improvement in UK’s trade balance will mostly come from a fall in imports driven by weak consumer demand, not an expansion of exports. It is therefore worth considering some of the reasons why the depreciated pound appears to be having a limited benefit for the UK’s export sector.

1) British exports tend to be price inelastic

What this means is that the demand for the goods and services which the UK exports tend to be relatively insensitive to changes in price. This is because many of these exports are high value-added goods and services such as banking, insurance and manufactured goods. These are sought after for their high quality, not their competitive pricing. As such a fall in price is very unlikely to suddenly encourage companies to purchase these goods and services where they would not have before.

The most relevant illustration of this was when the pound fell sharply in value between 2007-08, and had a comparatively negligible effect on the volume of UK exports. The Office for Budget Responsibility estimates that a 10% fall in the price of exported services will only increase demand by 2.2%. The general insensitivity of UK exports to changes in prices therefore partially explains why UK exports have not increased substantially since the referendum.

2) Export growth requires increases in demand and not just falls in price

Price decreases alone cannot create demand. Even if a country’s goods and services become more affordable internationally, they will only be purchased if there is a significant desire for them. Indeed, this is particularly true of the UK’s exports, which as discussed, are generally demand sensitive, not price sensitive. The growth prospects for the UK’s major export markets are weak, however, the U.S and European Union are only predicted to grow by 1.6% and 1.5% in 2017 respectively. Consumer confidence in the Eurozone is expected to slow in 2017, and the UK may not see a significant increase in demand for its products from abroad until the outlook improves in these export markets.

3) The rise in costs from the weaker pound has been of more significance for producers

While exporters may have experienced some benefits from the depreciated pound, the higher costs of raw materials and commodities such as oil brought on by the weak pound has arguably been of greater significance. The CIPS found that 90% of companies referenced the exchange rate as being a reason for an increase in average purchasing costs following Brexit. Indeed, the Bank of England’s report earlier this month stated that higher input costs due to the weaker pound had widely resulted in lower profit margins for companies. In the medium term, firms may be able to recalibrate the composition of their costs, but their ability to do so in the short term is largely restricted. Potentially more problematic is that the UK is a particularly specialised economy, and there could be limited scope for companies to substitute away from imported to domestically produced goods. The result of this would be producers and consumers sucking up the higher costs.

4) Uncertainty caused by Brexit has reduced investment

The most significant factor which has limited any positives that might be expected from the pound’s depreciation is the uncertainty brought on by Brexit. The impact that this has had on exports has been twofold.

First, many businesses are unwilling to invest to increase export growth until the UK’s future trading relationship with the EU and the rest of the world becomes clearer. This underlines real fears that the UK will opt for a hard Brexit which could see the UK’s products subjected to tariffs of over 10%. The EFF’s report shows that companies in industries which would face the highest tariffs under WTO rules, including automotive and food producers, are also not coincidentally the least willing to make investments. A large boost in exports would require companies to make significant investments to increase production of exportable goods and services, and given current levels of uncertainty, this seems unlikely. This is also true of foreign firms, many of whom have chosen to delay planned investments into the UK because of the threat of losing access to the single market.

The second issue is that fear of a ‘hard Brexit’ may make importers in both the EU and elsewhere reluctant to enter into new contracts with UK exporters. The UK is highly integrated into EU supply chains, with goods crossing borders multiple times during the production process. Until foreign companies are clearer on what the UK’s future relationship with the EU will be, many are worried about exposing themselves to potentially large risks. Fears of a ‘hard Brexit’ are unlikely to be relived anytime soon, and the UK will have to cope with a cloud of uncertainty hanging over it for some time.

Ultimately, it should be remembered that the depreciated pound is not a vote of confidence in the UK. It is a reflection of the fears about its future trading relationship with the world, and the potential negative impact that Brexit could have on the economy. While there is certainly a conventional wisdom about the benefits of a devalued currency, the trend towards increasingly specialised economies has arguably changed this. While there may be benefits of a weaker pound in the future, any positives appear relatively negligible so far.

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