EEF blog

Although we've blogged on how global demand - especially from emerging economies - is helping drive the recovery in manufacturing, today's news out of Ireland is a pretty stark reminder of the risks posed by the global economy.

The G-20 meeting in Seoul managed only loose commitments to resolve the economic imbalances behind the currency war.

China is signalling it’s concern about inflation (which is code for their going to let the reminbi appreciate), which has knocked 5% off the Shanghai markets. This could have been typical pre-G-20 posturing, or it could reflect significant concern about rampant credit.

And now rumours are swirling of Ireland requiring, but shunning a bailout.

Where does this leave UK manufacturers? Many UK businesses I’ve talked to are concerned about the impact on three key points: demand, costs and profits, with further Sterling volatility being the worrying wildcard.

The concern about demand

If goods exports to China have risen by 44% since the start of the year, a trade war involving China and other developing economies, such as Brazil, could undermine the demand that is helping to drive growth in the UK. Most manufacturers worry that, if the currency battles slip into protectionism, then developing economy demand may dry up, profits could get hit or materials costs could rise (e.g. China produces 97% of global rare earth mineral supply).  

So far, so good. But what will happen to UK exports if the UK doesn't try to competitively devalue its currency? Would that help mitigate the damage from a trade war? Would the UK be viewed by China, Brazil and others as a benign trading partner, and so avoid the worst of the restrictions? Or would UK exports become collateral damage, caught in the crossfire between the US, China and others?

With the bulk of exports still headed for the EU, UK firms will have a decent buffer against such global headwinds. But the longer a trade war between the US and China persisted, the more likely the global economy - and UK exports with it - will suffer.

Profitibility could be hit 

Over the past decade, many firms protected themselves against a strong pound by buying and selling in dollars and eruos rather than pounds. This is standard practice for firms operating out of small, open economies and with exports making a big contribution to turnover. This way, if sterling moves, then firms take the hit on profits rather than on orders. This is why, as sterling fell during the recession, EEF's Business Trends survey showed improving profit margins on exports, even as world trade fell.

What's this mean for a currency war?

If the UK doesn't try to devaule it's currency, sterling will probably rise, for example, relative to the dollar. As discussed above, this will hit profitability, while potentially protecting orders. The knock to profits could eventually feed through to greater caution on investment and employment intentions.

If the UK tries to devalue the pounds, for example, through further QE, then profitibility could be temporarily protected, but at the cost of demand if protectionist measures begin to bite.

Cost of commodities

Over the past couple of years, a weaker dollar has meant rising commodity prices. Allowing sterling to appreciate could insulate UK firms from rising costs, while also helping to dampen down inflationary pressures in the UK (as import costs reduce).

But as we said before, getting caught up in competitive devaluations could mean getting caught out on access to China's supply of rare earth minerals.

A spanner in the works

The one issue that could through all this analysis - and firms' best laid plans - out the window is further exchange rate volatility.

Stirling volatility over the past year or so made planning for the recovery difficult, and another bout of it could keep cash-rich companies' on the sidelines of the economy until the G-20 manages to either resolve the currency crisis or settle the Doha trade round.

This month’s trade figures don’t look good. Exports are down. Imports are up. The trade deficit in goods (or “visible exports”) is the largest on record.

So what’s going on with exports?

Firstly, it is the export of goods (not services) that has fallen, and this has fallen even after excluding erratic items which tend to skew statistics.

The volume and the price of goods traded have fallen. The fact that prices have fallen (and have been falling since March) is worrying because it suggests that exporters have not been able to take advantage of the exchange rate and increase their margins.

Visible exports to both E.U. and non-E.U. countries have fallen, but it is interesting to look at the breakdown of these. Outside of the E.U. the largest fall in exports went to the U.S. where exports fell by 6.4% over the month. It is likely that the still shaky economic outlook is dampening U.S. consumers’ and businesses’ demands for U.K. goods. Conversely, U.K. exports to high-growth China and South Korea have risen notably.

A similar picture is notable in Europe, where the largest falls in exports were to Spain and Italy, in both cases falling by over 10%. This suggests, then, that weaknesses in the economies of export partners might be behind this month’s disappointing statistics.*

This does mean, though, that the fact that the UK’s imports have increased isn’t necessarily a bad thing. If imports are growing that is because domestic demand for imports is growing, which suggests that consumers and businesses have become more confident.

*Although this doesn’t explain the fall in exports to Germany, which was also quite significant.

Coming back to trade, I think we still should expect some boost to net trade from the devaluation. In the short-term I think it’s completely understandable for exporters to pocket an additional margin. A big part of that has to be the uncertainty at the moment with demand. With the recession still very fresh in exporters’ minds, they have to be wary about increasing production. Plus increasing production can soon run into capacity limits, particularly if capacity has been reduced during the recession either permanently or in ways that are not easily reversible. So if you’re looking at a big investment to ramp up your productive capacity you want to be sure demand is going to be there to deliver a return.

But putting this uncertainty to the side for a moment, isn’t there an opportunity for our exporters to increase their exports through at least some of that devaluation appearing as lower prices? In the longer term aren’t we made more competitive by a structural shift in the exchange rate? And isn’t that what we’re relying on to boost the UK’s recovery and rebalance the economy?

Maybe, but there are several other things we need to consider. For a start the competitive (or not very) situation facing some exporters. If a lot of firms export similar products then chances are at least some might try to take advantage of a devaluation to capture higher market share by offering lower prices than competitors. How many exporting sectors this would apply to though might be questionable, particularly if many produce highly differentiated products with no real substitutes.

I mentioned above uncertainty on demand perhaps discouraging investment but there could be other barriers to expanding capacity. A really topical one at the moment is access to finance. Some of our recent research and discussions suggest, perhaps not surprisingly firms overwhelmingly favour internal finance – retained earnings mainly – to fund expansion. While expansion can be risky meaning debt finance may not be appropriate there are other forms of external finance that might be. Barriers facing particularly our smaller firms in accessing say, new equity, might be one reason why it might take some time to expand capacity.

What about a deterioration in trade finance, possibly particularly important to fast growing developing economies where trade is commercially riskier. Following the onset of the financial crisis, there was a pretty appalling withdrawal of trade finance and I had heard that while it’s coming back, premiums between countries have spread much more than pre-crisis. Could this be limiting the expansion in exports?

None of this is the full explanation and as per the latest official growth outturn (and our own research), exports do now appear to be gathering momentum at last. But it would be interesting to dig more into the significance of each of these factors…

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?