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Economist InsightsExchange wait
15 April 2013Asset management
If you have just graduated from a macroeconomics course
and are looking for a country to apply your knowledge to,
then do not look at the UK. The UK economy has been the
cause of headaches for many economists, including those
at the Bank of England (BoE), because it does not seemto operate the way it should. One headache has been the
unusual behaviour of employment and productivity (see
Economist Insights, 25 March 2013); another has been the
stubborn persistence of the UK trade deficit.
Economics professors teach us that a persistent depreciation
in a countrys currency should lead to an improvement in
competitiveness and therefore in the trade balance. The pound
(GBP) has devalued so imports into the UK should be more
expensive and exports should be cheaper for foreigners. After
the UK left the Exchange Rate Mechanism (ERM) in 1992, GBP
depreciated significantly and the trade balance improved as
expected, moving from a deficit of 4% of GDP to a surplus ofalmost 1% (see chart 1). Conversely, the strong appreciation of
GBP in the mid-90s caused the trade balance to worsen to a
deficit of about 3% of GDP.
Given this past, nicely-fitting pattern, you would have expected
the 25% depreciation of GBP during 2007-2008 (one of the
largest on record) to have pushed the trade balance back to
positive territory. Yet more than four years later, the trade
balance has shown no real improvement. This failure to react
has been particularly confounding for the BoE. The BoE had
hoped that its loose monetary policy would weaken the
exchange rate and hence help the UK economy grow into amore balanced, export-led economy. The first part was achieved
but the improvement in the economy and the trade balance
remain elusive.
One related factor is certainly the health of the UKs major
trading partner, the Eurozone. The crisis, fiscal consolidation
and on-going weakness in the Eurozone have kept demand
for imports very depressed. Even if the depreciation has
made UK exports more competitive, if people in the
Eurozone are not buying very much that price advantage is
less of an advantage.
Weak demand in the Eurozone may explain some of the UK
trade balance underperformance, but on its own it is not
enough. To fully understand the trade balance developments,
you also need to examine the composition by types of goodsand services of that balance and how it has evolved since the
early 1990s.
Joshua McCallum
Senior Fixed Income Economist
UBS Global Asset Management
joshua.mccallum@ubs.com
Gianluca MorettiFixed Income Economist
UBS Global Asset Management
gianluca.moretti@ubs.com
Source: ONS, Bank of England, UBS Global Asset Management
Chart 1: Breaking relationship
UK trade balance and nominal effective exchange rate (NEER)
-4
-3
-2
-1
0
1
2
NEER (rhs-inverted, deviation from 1990 2012 average)
Trade Balance (lhs, % of GDP)
Strong
Weak
Q1-1990 Q3-1995 Q1-2001 Q3-2006 Q1-2012
-20
20
15
10
5
0
-5
-10
-15
The UK economy has caused headaches for economists
because it does not seem to operate the way it should,
noticeably in the stubborn persistence of the UK trade deficit.
GBP depreciated by 25% during 2007-2008 but four years later
the trade balance has shown no real improvement. A large
part of the explanation lies in the change in sector composition
of the trade balance since the early 1990s. The boom in thefinancial services sector in the 90s caused a strengthening of
the exchange rate which weakened other sectors. As a result, a
rebalancing towards a more export-led UK economy may take
much longer.
http://www.ubs.com/content/dam/static/asset_management/global/research/insights/economist-insights-20130325.pdfhttp://www.ubs.com/content/dam/static/asset_management/global/research/insights/economist-insights-20130325.pdfhttp://www.ubs.com/content/dam/static/asset_management/global/research/insights/economist-insights-20130325.pdf7/28/2019 Economist Insights 15 April2
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The UK trade balance has always been characterised by a
surplus in the service sector and a deficit in the goods sector.
The post-ERM devaluation led to an improvement in the trade
balance for all sectors with the exception of financial services,
which retained its surplus broadly unchanged (see chart 2).
Visit any industrial town in the north of England and they will
tell you that the sharp and persistent appreciation of GBP in
the 1990s was very painful for UK goods-producing sectors,
especially manufacturing. In the following decade the trade
balance for manufacturing worsened by almost 2.5% of GDP.
The share of manufactured goods as a percentage of total
exports fell from 42% in 1998 to just 27% by 2007.
By contrast, ask anyone in London about exports over that
period and they will identify one sector that seemed to
do nicely despite the exchange rate: financial services. The
financial services sector saw its share of exports double from7% to 14%. Thanks to the strength in financial services in
particular, the trade deficit only worsened to 3% of GDP. But
this improvement in services masked the massive weakness in
exports of manufacturing and other goods (even North Sea
oil, due to shrinking production and ageing, inefficient power
stations). Without the services improvement, the trade deficit
would have been around 6.5% of GDP.
The manufacturing decline was not just a UK problem.
Manufacturing sectors across developed markets were in
relative decline as the principle of comparative advantage
played out: developed markets specialised in services and niche
manufacturing while emerging markets specialised in massproduction manufacturing. On top of that natural economic
occurrence, a number of countries, notably China, kept their own
exchange rates artificially low in order to gain an even bigger
advantage for their manufacturers. Even so UK manufacturing
exports underperformed the rest of the world. In the UK, the
manufacturing sector was excessively penalised by the relative
strength of the financial sector. A strong and productive financial
sector meant counterbalancing exports but also large capital
inflows and foreign direct investment into the UK. The BoE also
had to keep interest rates higher to contain inflationary pressure in
London and the South East, even though the rest of the country
would have much preferred lower interest rates.
In short, the UK suffered from an economic condition similar
to Dutch disease: where one booming sector (finance in the
UK; in the Netherlands it was gas) causes over-appreciation of
the exchange rate, higher rates and wage inflation, all of which
weaken the rest of the economy. This in turn leads to lower
investment and a decline in the structural capacity of those
other sectors. Factories shut and skills are lost. Consumers
become used to buying imported goods, putting further
pressure on domestic producers.
This structural decline may go a long way to explaining why
the massive exchange rate depreciation did not translate into
improved manufacturing exports. It is hard to quickly increase
exports when the factories are shut, or the skilled workersare unavailable. And even though interest rates are now low,
credit availability is so constrained that most firms cannot
benefit. Imports now make up such a large proportion of goods
purchases that consumers would have to be extremely sensitive
to prices before domestic producers would feel much benefit.
Hence manufacturing has only managed to squeeze out a small
improvement in trade balance since 2008 and is nowhere near
its past peak. All other goods, along with the crisis-hit financial
sector, showed worsening trade balances since 2008. Only
other services managed to provide an offset, which reinforces
the message from the manufacturing decline: other servicesectors had the capacity and skills in place to take advantage of
the lower exchange rate.
Some anecdotal evidence suggests that UK exporters have
been using the exchange rate to increase their profit per item,
rather than to increase market share. Perhaps this reflects
limited capacity to expand, but at some point it seems likely that
they will want to expand capacity. Eventually banks will have
adjusted their balance sheets, or the BoE will have managed
to incentivise more lending, and cheap credit will flow once
again. If big trading partners like the Eurozone or (more likely)
the US manage to grow again, then perhaps the outlook for
UK manufacturing exports will improve. Economics all too oftentends to assume that the market moves from one equilibrium to
another very quickly, but in the real world we may have to wait
longer for the exchange rate to help as long as the BoE can
keep the currency weak.
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Chart 2: Ill-positioning
Change in trade balance by sector, % of GDP
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Other ServicesFinance & Insurance
ManufacturingBasic Materials & EnergyOther Goods
2008 20121998 20071990 1997
Source: ONS, UBS Global Asset Management
Note: Other Goods includes food, beverage and semi-manufactured products.