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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.pdf

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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.