EEF blog

Yesterday Andrew asked why it was that UK exports haven’t grown more strongly, especially compared with the export growth that has been seen in Germany.

One point I find particularly interesting is that Germany has seen export growth despite the appreciaiton of the Euro. Following the depreciation of Sterling it seems counterintuitive that export growth has been so dismal: prices go down, sales go up, right?

This doesn't appear to be the case, but perhaps this is because price is not the only thing purchasing decisions are based upon. For the average consumer, loyalty (or inertia) plays a part: I might keep going to a particular coffee shop even though it gets more expensive and another is getting cheaper. And this might not even be because the coffee in this particular shop is better; I’m just used to going there. Used to the route I take to the shop. And the staff are used to me ordering the same thing.

Well inertia applies to exports too. The so-called J-curve charts a relationship between exchange rate depreciation and a (temporary) worsening in the current account balance. This is based around the idea is that straight after a depreciation customers don’t switch suppliers, because they’ve placed orders with them, or they’re used to that way of doing business etc. The current account worsens because importers are doing the same thing, only the imports are now more expensive.

Eventually – after a time lag – customers realise they could be getting a better deal and they switch suppliers, and net exports improve.

Or do they?

Let’s go back to my coffee shop scenario – I’m considering switching coffee shops: I’m a bit fed up with how much I’m paying. The problem is the price at the second coffee shop seems to change every day. It swings by enough to mean that sometimes the extra effort of walking the five minutes it takes to get there isn’t really worth it. How do I know if I really want to bother going to that shop?

The answer is: I don’t. And with the huge currency price-swings we’ve been seeing it means there’s a possibility of getting stuck in a long-term J-Curve situation.

This is not necessarily bad for manufacturers. If customers are less price-sensitive it means that if manufacturers choose to maintain relative prices (by increasing nominal prices) they will be able to increase their profit margins and benefit from the exchange rate depreciation in this way. Evidence from our Business Trends Survey showed that during the recession UK manufacturers were doing just this.

But what does this mean for export-led growth prospects? When we talk about rebalancing the economy, improving the external balance of exports less imports is a key factor. Can we really rely on the lower value of Sterling to boost exports, or will it take more than that?

I was on a conference call with a colleague yesterday discussing the state of trade for UK manufacturers. The discussion turned to why the German economy seems to be doing better than the UK. Germany recorded a post-unification high of 2.2% growth q/q in 2010 Q2, largely on the back of a strong exporting performance.

My colleague noted recent comments from the Bank of England’s Charlie Bean that Germany exported more capital goods relative to the UK. Strong Chinese demand for German goods like ventilators, electric motors, fridges, dryers, and cars is a key part of the German export performance. So much so in fact that some commentators have been wondering whether Germany might be becoming too reliant on China given some talk of slowing in the world's second largest economy.

This got me thinking about a number of articles in the media recently about German exports to China, the Chinese economy generally, and whether boosting exports to the Far East is a sustainable strategy for the West to return to solid growth.

So looking a little closer at what’s happened recently, I see that Germany’s surging exports to China, smashed on at an annual growth rate of over 30% . But German exports still focus predominantly on Europe, even more than the UK.

Indeed Germany still exports roughly three quarters of its goods within Europe – far more than the c14% that goes to Asia . So the Chinese story is more about growth of exports. Though it should be noted that exports in June were up 22% on June 2009 for EU countries, so growing well, even if short of the 37% increase to countries outside the EU.

How does this compare to the UK? Well in 2009 the UK sent just 2% of its exports to China , certainly less than Germany’s 4.5%. In terms of growth, exports to China were among the few UK export locations that saw an increase in the 2009/10 year, after trade took a hammering following the financial crisis. Bar 2009, year-on-year growth of exports to China has been in the double digits but no evidence I've seen so far suggesting growth as strong as Germany's. The sorts of things that are exported include medicine, petrol, engines/motors, and cars so not a perfect fit with the Charlie Bean capital goods v consumer goods explanation.

I think there’s more to it.

Why do the Germans seem to have an export-powered growth advantage over the UK at a time when the £ has depreciated by c25%, supposedly making our exports more competitive?

One important comparison to bear in mind is that Germany is simply a bigger exporter than the UK. In 2008 the UK’s exports were worth a bit over quarter of its GDP – but the Germans were 20pp higher, at 47%. In terms of net position, the UK has lately found itself in deficit, whereas the Germans are consistently in surplus - that is, contributing to overall growth.

So in 2009 when the recession shrank the UK and German economies by 4.9%, there was an even bigger drop in trade of 25%. The steeper decline in trade is mirrored now by a steeper rise, as trade in goods in particular trade rebounds. The pattern of growth follows this structural difference. Perhaps the bigger mystery following this logic is not why Germany is growing faster now but why Germany didn't drop further during the recession, as Japan for example did.

Perhaps it's not a question of the UK doing badly at all. It posted 1.1% growth q/q in Q2, better than almost all predictions and better than almost all developed countries (except the Germans of course). Though in our case trade wasn't the engine of growth and it is a puzzle that exports are not growing more strongly, given the depreciation in sterling. This is a puzzle that is both perplexing now and important for the longer term, as many see the expansion of exports as a key part of the rebalancing act the UK economy needs to drive its future growth.

This is a good overall performance, though likely a local peak for growth in the short term. For exports, particularly to places like China, another important difference between the UK and, say, Germany is our higher focus on services - I think that's more important than consumer v capital goods differences. Although we exported 2.4% of our goods to China in 2009, only 1.45% of our services exports went there and within those just 0.5% of our financial services exports and 0.9% of other business service exports. China has a lack of demand for UK service exports.

All this leaves me feeling that more is certainly possible. Apart from our German friends, Europe – our major export location – is growing only weakly. Emerging markets have long been identified as the future for UK exports and yet our presence in places like China is still small. A rebalanced economy needs to see net trade helping drive overall growth – far from the drag it currently represents - and that is going to need higher exports to places like China.

In my view the opportunities from putting more effort into China far outweigh the risks. In the medium term, the outlook for the Chinese economy is very strong.  Growth is forecast to be closer to 10% than 5% for both this year and next. There is external pressure for a revaluation of the yuan  and internal pressure for higher wages. Both of these pressures are likely to lead to higher demand for consumer goods – and potentially services – benefitting the UK. And the terms of trade would tilt to better favour our exports.

I still feel there’s more to understand here. Why aren’t exports growing more strongly and what more could be done? Are there any differences with Germany that we could learn from? When, if ever, are we going to get a proper kick from the sterling depreciation?

FT Alphaville highlights a near 50-year low in 10-year gilts and puts the blame for this fall squarely at the feet of bearish comments from new MPC member Martin Weale in the Times:

'It would be “foolish” to rule out the possibility of a double-dip downturn, even if it was not the Bank’s central prediction, said Dr Martin Weale, the newest member of the Monetary Policy Committee (MPC). He also feared that the Bank’s central outlook — which is for growth of about 2.8 per cent in 2011 and 3.2 per cent in 2012 — could be too optimistic…

Dr Weale said that the Bank’s latest economic forecasts, published on August 11, had a 10 per cent outside chance of four-quarter long economic contractions in 2011 and 2013. “The forecast is putting a significant chance on the economy contracting over a four-quarter period,” said Dr Weale.'
 

The link between Weale's bearish-ness and the drop in gilt yields raises questions about what effect yields will have on business investment (remember - the Chancellor and the OBR are staking their reputations on fiscal restraint lowering 10-yr yields and so helping to encourage business investment).

So what's pushing 10-yr yields close to record lows?

Well three factors: global risk, domestic weakness and fiscal consolidation.

Let's breifly take those in turn.

1. Global risk. With the global recovery stumbling and sovereign default still a moderate risk, investors are seeking safety in the arms of US, UK and German government bonds. As demand for these longer-term bonds goes up, so does their price, pushing down the yield. So far, so good. The problem is the affect on business investment. If financial markets are shunning risk, then its because there's something worrying about the state of the global economy. Concerns about the global recovery makes businesses uncertain - and that's why most are sitting on piles of cash and holding off on investment.

2. Domestic (UK) risk. Well, a weak economy typically favours bonds as investors move out of relatively riskier equities in favour of relatively safer goverment bonds. This is the sentiment behind the Weale-driven dip in yields. But yet again, domestic weakness will make businesses cautious about investing.

3. Fiscal consolidation. I'll put this upfront so there is no second guessing our views: this isn't a 'deficit denier' arguement. There is a deficit, it needed to be tackled and EEF supports most of the government fiscal consolidation plans. And tackling the structural deficit will provide downward pressure on gilt yields (or at the very least limit any upward pressure). The question we're raising about the affect on investment. The government is making a 'crowding out arguement' that says shrinking the deficit will lower rates and boost private sector investment. Not only is this arguement weak - all interest rates were low prior to the recession, which was part of the problem behind the financial crisis, so there's only a weak case for the government to make. Add on top the uncertainty caused by their unnecessarily deep capital spending cuts, and you've got businesses being cautious about investment because they've got concerns about their public sector-related orders.

So in reality, two of the three drivers pushing gilt yields down will naturally imply only limited growth in business investment. And the government's gamble on fiscal consolidation boosting investment actually cuts both way, providing an uncertain benefit.

GM announced yesterday that it would offer a “lifetime guarantee” on all of its Opel and Vauxhall cars in Europe (the offer extends up to 100,000 miles – which for my Dad wouldn’t be a lifetime – but perhaps that’s best kept for another blog) . This is part of a trend in the car industry to offer ever more generous guarantees or add-ons rather than compete on price.

Non-price competition is nothing new, but it’s likely that we will see more of it. Coming out of recession and with consumer demand still weak, companies will be looking to ways to distinguish themselves from competitors. However, with margins being squeezed by exchange rate fluctuations; supply chain weaknesses; and high commodity prices, companies will not want to have to compete on price.

It’s an interesting question as to whether these add-ons are a good idea in the long-term. Yes, a lifetime guarantee will help establish trust with consumers and provides a unique marketing opportunity, but there are potentially significant long-term costs. In addition this could lead to some kind of non-price arms race: the industry norm for a guarantee used to be three years, with five, and even seven year guarantees having been offered of late. Then again, if these kind of offers can spur on ailing consumer demand, perhaps they’re just what the doctor ordered.

Mervyn King and the MPC boys must have a soft hedge around the back of the Bank of England. Otherwise it must be pretty uncomfortable sitting on the fence for 17 months in a row. That’s just been confirmed by today’s announcement that the MPC will leave the official Bank Rate unchanged yet again.

It’s a call we agree with but will still no doubt cause some considerable commentary. That’s because beneath this apparent continuity the swirl of economic signals is becoming ever more complex, making monetary policy setting a tricky business.

Let’s look first at the case for loosening policy even further (which would mean more QE).

The motivation for this might be a belief that growth prospects are weakening, that inflation pressures, like VAT, are temporary, and that the bigger medium term risk is actually deflation. Deflation is bad because it encourages consumers and businesses to hold off spending and investing because their money will be worth more in the future – not what you want if demand is falling.

We know the MPC discussed this in July. What about this month?

The main problem for further easing is concern on inflation expectations. Expectations play a big role in determining actual inflation because of the way they impact on pricing behaviour in the economy e.g. wage demands – I expect inflation to be higher, so I want a higher wage increase than otherwise from my employer.

To keep to its 2% CPI annual increase target, the MPC needs expectations to be anchored. Consistently over-shooting this target undermines this anchoring.

Inflation has now been above target since December. The rise in VAT in January will probably keep inflation above target until the end of 2011 – two years of above-target inflation. That will really test how well anchored expectations are. Will people simply think to themselves “you know what, prices just seem to go up faster these days” and change their behaviour accordingly?

Recent strong manufacturing output growth and upside surprises for the economy generally, while good news, probably further limit the appetite for loosening. Demand could eventually outstrip the (somewhat uncertain) spare capacity of the economy and flow into higher prices. This too would push inflation up.

All this seems to argue against loosening – so what about tightening? (or 'normalising' as the hawks like to say).

We know this too was discussed in July. In fact one MPC member – Andrew Sentance – actually voted to hike Bank Rate and he’s likely to have called again for the song to be changed.

Why? Perhaps based on confidence the recovery is underway coupled with a fear that spare capacity is low and inflation is proving too persistent.

The problem with this view is that it may be too short term. Given long and uncertain lags in inflation and its response to monetary policy, policymakers have to focus on the medium term – roughly 18-24 months ahead.

If anything, since July, medium term prospects for the UK have slightly dimmed. Business and consumer sentiment surveys show domestic confidence waning.

As in July, we know there’s a considerable fiscal consolidation coming down the road. The Coalition will announce the detail of its Spending Review on 20 October.

The source of any upside to growth therefore would appear to have to come from the recovery’s so far disappointing net trade. But is that likely?

Well, recent reports suggest growth in the U.S. and China is moderating. Uncertainty over jobs, fiscal contraction, and a weak housing market are weighing on American consumers. In China growth also appears to be slowing from the first half of the year as the government looks to normalise fiscal and monetary policy (though still likely to top 8% for the year!).

Over in Europe our biggest export market has had a little more mixed news. Continuing weakness in the periphery has been offset somewhat by a stronger-than-expected German performance. But the Europeans, like us, face a looming fiscal consolidation – which for some looks really tough, with lingering sovereign debt fears.

I think the sum of all that makes you hesitate before pushing ahead with any tightening. Higher interest rates could further choke off both investment and consumption just as demand is beginning to slide – a threat to the recovery.

Where does that leave us? Back on the fence of course.