Is the depreciation of sterling a good thing for the economy?

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In recent weeks sterling has been falling.

One pound will now buy you about €1.17. On January 1st this number was €1.23; you could have had an additional six Euro cents for every pound you traded as little as a month ago.

The reasons are better sentiment about Europe, and weak UK GDP data.

This has been brought about largely by better sentiment with regards to the Eurozone. As exits from the currency region have looked less likely, so the Euro has become stronger. However, the pound has also fallen more recently following poor GDP numbers announced on the 25th January.

These GDP numbers suggest that the UK economy shrank again in the fourth quarter of 2012, and a fabled ‘triple dip recession' is looming. Although we expect some growth in every quarter this year, a weaker 2012 hits our forecasts for 2013, and the impact of last week's data – taken in isolation – would imply that the UK economy will now grow a meagre 0.8% this year.

But nothing ever happens in isolation, and as sterling falls, there is the inevitable question as to whether this will benefit the economy.

There are some benefits associated with a weaker currency.

The good news is that a weaker pound should be good for exports. We forecast that if the pound were to remain at its current level throughout 2013, then exports would be about 1% higher than in our baseline forecast.

This would be positive for the economy, and GDP growth would be around 0.2 percentage points higher than in our baseline scenario.

But the benefits of depreciation don't always play out in reality.

As we saw earlier in the recession, when sterling fell markedly, exports did not perform anything like as strongly as expected (see this blog from 2010 where we've discussed this issue)

Andrew Sentence explained this pretty neatly in an article for City AM last week.

“Exporters in a mature industrialised economy like the UK do not respond to short-term currency movements... British exports are… not highly price-sensitive. Within manufacturing, our main exports are high value-added products which sell on the basis of quality and technology.”

And there are losers from a weaker currency too.

In addition, even if a weaker sterling is good for exporters, it's not great news for companies that import a large proportion of their inputs, and it's not good news for consumers. Because weaker sterling increases the prices of imports, a depreciation of the exchange rate will boost inflation.

Under our depreciation scenario, CPI would average 2.8% over 2013, compared with our current forecast of 2.2% this would further increase the squeeze on households (knocking 0.2 percentage points off growth in consumption in 2013) and this may lead to increased wage pressure.

Nonetheless, weaker household spending offset by stronger exports would be positive, in the sense that this is part of the rebalancing our economy needs to see, but this can't be guaranteed. In particular, if trouble erupts in Europe again, there may be further swings in exchange rate, that more than negate the advantages of a depreciation.

Exchange rate volatility poses challenges for companies.

Unstable currencies can be hugely problematic for companies who are engaged with international markets. A volatile exchange rate can make it difficult to set prices and erode margins within a matter of weeks.

In our recent Executive Survey, 37% of manufacturers told us that they saw significant movements in exchange rates as a key risk to their business in 2013, with medium and large sized companies – those more likely to be exposed to multiple export markets – particularly concerned about this risk.

While there are reasons to think sterling's recent depreciation might benefit the UK economy, things are rarely as straightforward.

Further reading: Sterling depreciation... a side note


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