David Smith reviews the likelihood that sterling might return to a more manageable level for exporters
T hose with elephant’s memories will recall that sterling’s strength goes back a very long way. Between ‘Black Wednesday’ in September 1992 and the summer and autumn of 1996, exporters enjoyed a competitive pound. Sterling’s post-ERM (exchange rate mechanism) devaluation led to a noticeable improvement in the UK’s external position.
The trade deficit in goods, nearly £25 billion in 1989, narrowed to just over £12 billion by 1997. The current account, the broadest measure of Britain’s balance of payments position, slid from a deficit of more than £26 billion in 1989 to one of less than a billion in 1997. When you hear Gordon Brown complaining about the economy he inherited from the Conservatives, bear that in mind.
What’s the position now? The combination of years of a strong pound and big increases in domestic demand has transformed Britain’s external position for the worse. In the third quarter last year, according to the Office for National Statistics, the current account deficit was a horrible £20 billion. In just three months Britain had nearly as much red ink as in the whole of 1989, which was regarded as a very bad year at the time. Even adjusting for inflation, this was a very bad figure. The current account deficit was £50.2 billion in 2006 and no less than £55.5 billion in the first three quarters of 2007.
If you want to get really depressed, meanwhile, look at the trade deficit in manufactures. In 1997 the trade deficit in manufactures was £7.4 billion. By 2006 it had soared to more than £53 billion. It looks as though the deficit for 2007 was about £57 billion.
So why am I revisiting the subject now? After all, it is only recently that sterling was giving every impression of great strength, trading well above $2 at a 26-year high against the dollar. Even while the pound was strong against the dollar, however, it was slipping against the euro.
In January 2007 sterling peaked at more than 1.50 euros to the pound. It remained just a little below this level until the summer, and then slipped a few cents. In November and December, however, sterling began to fall sharply as the Bank of England signalled then enacted a cut in interest rates, closing the gap between UK and European interest rates. By early January, the pound was just above 1.30 euros, a big downward shift. At time of writing sterling had bounced up a little against the euro on speculation that European interest rates will, in time, come down.
But weighing on the pound are that big payments deficit, and fears that some of the forces that have kept the economy growing in recent years, including housing, the consumer and public spending, are fading fast. Sterling may also have suffered from the powerful perception in financial markets that the Bank, Treasury and Financial Services Authority lost control during the credit crisis and mishandled Northern Rock.
Let us assume that the pound, while not collapsing, remains at lower levels than in the past against the euro. It would not lead, of course, to an instant revival of UK trade, despite the fact that 55 per cent of Britain’s goods exports go to the euro zone economies.
The immediate effect of a fall in the pound is likely to be to worsen the deficit as imports become more expensive but have not yet been replaced by domestic goods. Economists call this the J-curve. Many UK manufacturers source components in countries either in the euro zone or linked to the single currency. Switching to suppliers in Britain cannot be done overnight, even if the currency shift is thought to be permanent.
It is also the case that a large part of Britain’s trade deficit is ‘structural’, reflecting the fact, for example, that there is not a large enough manufacturing base to meet domestic demand.
At the margin, however, a lower pound will help manufacturers. It has been a long time coming but this is a welcome step towards the rebalancing of the economy. Maybe we will see those big external deficits start to narrow.