FX International Payments
By Frances Coppola
Economic theory says that exchange rate depreciation benefits exporters, since the price of goods in foreign currency effectively rises, improving revenue without increasing sales. Even if exporters respond to this windfall by cutting prices in foreign currencies, sales volumes can increase. Conversely, importers suffer in a depreciation, since the sterling price of imports rises, discouraging demand for them. Thus, a large fall in the pound's trade-weighted exchange rate should improve the U.K.'s international competitiveness and reduce its historically large trade deficit.
But one year on, there is as yet no sign of rebalancing. Domestic inflation in the U.K. has ticked up due to rising import prices,3 leading analysts to speculate that the Bank of England may raise interest rates.4 But despite sterling's devaluation, the U.K's trade deficit has not fallen.5
In a new report, the U.K.'s Office for National Statistics (ONS) attempts to explain why exchange rate depreciation has not had the effect many anticipated.6
As the ONS explains, many U.K. businesses import raw materials and intermediate goods for final assembly. Additionally, the U.K. is a net oil importer; as oil is priced in U.S. dollars, sterling's exchange rate depreciation versus the dollar limited the benefit to businesses from falling oil prices. Consequently, the pound's falling exchange rate caused the cost of imported business inputs to rise. The ONS shows that sterling depreciation caused business import prices to rise nearly 20 percent by February 2017, though the rate of increase has since slowed as sterling's exchange rate has strengthened, notably against the U.S. dollar.7
On the export side, the ONS says that sterling depreciation caused a large increase in revenue of goods exporters. This was due to currency exchange rate effects; if exports are sold in foreign currency, then when the pound's currency exchange rate falls the sterling price of goods rises, increasing revenue without any increase in sales volume. The ONS finds no evidence that businesses cut the foreign currency price of exports to improve international competitiveness; sales prices in foreign currency rose more-or-less in proportion to sterling's effective exchange rate fall. In effect, businesses have kept the windfall from sterling depreciation. Some may have done this to offset higher input costs, while others may simply have been slow to adjust foreign currency prices.8
Economic theory says that although trade competitiveness improves following exchange rate devaluation, it may take a while for this effect to develop. In the short term, the trade position may even worsen – as it has for the U.K. This is known as the "J-curve effect."9
In a J-curve pattern, the country's trade deficit widens immediately after exchange rate devaluation. This is simply a short-term valuation effect: import prices rise while export prices fall, increasing the value of imports and reducing the value of exports in the devalued currency. Over time, though, higher import prices discourage domestic consumers from buying imports, encouraging them instead to purchase locally produced substitutes or simply cut back on non-essential purchases. Import volumes therefore fall.
On the export side, businesses may choose to improve their external competitiveness by cutting foreign currency prices, encouraging trade partners to increase purchases and thus raising export volumes.
So is the U.K. experiencing a J-curve effect? The ONS says that the goods trade balance did widen during the 2015-16 exchange rate falls, consistent with a J-curve.10 And although the ONS has not found any evidence thus far that U.K. businesses have taken advantage of the pound's falling exchange rate to increase sales volumes, they may still do so. In its August 2017 Inflation Report, the Bank of England forecast a sustained improvement in export volumes. "The rise in export margins is likely to support an expansion in export volumes among firms with spare capacity," it said. "As that capacity is eroded, and for firms with limited spare capacity, those higher margins should provide an incentive to invest, thereby boosting export volumes over time."11
The 20 percent decline in sterling's trade-weighted exchange rate since 2015 has not as yet resulted in significant improvement to the U.K.'s trade position. However, if sterling's exchange rate remains low, the U.K. may become less attractive for imports, while its exports may become more price competitive. Over time, therefore, the U.K.'s trade deficit could fall.
With 17 years' experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Let the pound fall and the economy rise,” The Guardian; https://www.theguardian.com/business/2016/oct/16/let-the-pound-fall-and-the-economy-rise
2. “Will the drop in sterling boost UK exports?,” Financial Times; https://www.ft.com/content/18048862-6519-3cbb-8c3a-149ce6d9a982
3. “UK Consumer Price Inflation: August 2017,” U.K. Office for National Statistics; https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/aug2017
4. “RBC forecasts Bank of England interest rate rise in November 2017,” Financial Times; https://www.ft.com/content/874579aa-12d6-33e8-998f-9a0a48e796e4
5. “UK trade: July 2017,” U.K. Office for National Statistics; https://www.ons.gov.uk/economy/nationalaccounts/balanceofpayments/bulletins/uktrade/july2017
6. “The impact of sterling devaluation on prices and turnover in the UK manufacturing sector,” U.K. Office for National Statistics; https://www.ons.gov.uk/economy/inflationandpriceindices/articles/theimpactofsterlingdevaluationonpricesandturnoverinthemanufacturingsector/2017-09-15
9. “J-Curve Effect,” Investopedia; http://www.investopedia.com/terms/j/j-curve-effect.asp
10. “UK Trade: November 2016,” U.K. Office for National Statistics; https://www.ons.gov.uk/economy/nationalaccounts/balanceofpayments/bulletins/uktrade/nov2016
11. Inflation Report, August 2017, Bank of England; http://www.bankofengland.co.uk/publications/Documents/inflationreport/2017/aug.pdf