Solid growth in manufacturing and across the wider UK economy over the past year has helped to propel sterling to a five-year high against the US dollar and on a trade-weighted basis. A sign of economic strength or a cause for concern?
After a long period of overvaluation, sterling's real trade-weighted value declined by 30% between mid-2007 and early 2009, falling below its long-term average. This was driven by economic weakness and sharp monetary policy loosening. Sterling recovered some ground in 2010-12, before weakening again in early 2013 amid renewed (if unfounded) concerns over a "triple-dip" recession. Since June 2013 sterling has strengthened steadily—by around 10%—in response to an unexpectedly rapid rebound in UK output growth.
Sterling real effective exchange rate(Jan 2005=100)
Source: Bank of England.
In trade-weighted terms the currency remains 19% below its pre-crisis level. The decade up to 2007 was an anomaly, however, during which sterling traded well above its long-term trend—in the process doing substantial damage to the tradeables sector of the economy. At such a level, investment in manufacturing in the UK was largely unprofitable for all but the most price-insensitive products. Partly as a result, Britain ceded more global market share in manufactured goods than almost any other OECD country during this period.
Viewed over a longer perspective, the current value of sterling is broadly in line with its 1992-97 average.
For the most part, sterling has followed a similar trend against the dollar and the euro since the crisis: weakening sharply against both currencies in 2008-09, recovering moderately in 2010-12, falling back slightly in early 2013, and then strengthening over the past year. More recently the picture has differed. Since May 2013 sterling has strengthened by around 10% against the dollar, compared with a more modest 3.5% against the euro. The respective US$:£ and €:£ exchange rates are each still around 20% weaker than their pre-crisis peaks.
Standard theory or new reality?
Policymakers are generally happy for sterling to weaken, in the belief it will give a shot in the arm to the export sector—via cheaper UK goods in world markets and improved competitiveness—and support a rebalancing of the economy towards increased trade. This explains some recent unease in the Bank of England at the strengthening of the pound, amid fears it could hinder the recovery.
But the recent story in the UK casts some doubt on whether traditional exchange-rate theory still holds. Despite the large 2008-09 depreciation, there has been no significant change in the long-standing pattern of UK trade, whereby a large deficit on trade in goods is only partially offset by surplus on the services balance. The value of UK exports has remained broadly flat since mid-2011.
Source: Office for National Statistics.
A long period of weak demand in key export markets has undoubtedly been a major factor. But there are likely to be other explanations too. UK exporters' relatively low exposure to stronger demand in emerging markets; a heavy reliance on key commodity imports of energy and food, the costs of which increase as the currency weakens; the UK's comparative advantage in services and high-value goods, which are less price-responsive; rising incidence of crossborder trade within larger firms, implying less sensitivity to the exchange rate; a loss of relative competitiveness with Germany (which is continuing to bear down on labour costs) and the US (where a shale gas revolution has sharply reduced energy costs); and ongoing structural issues affecting non-price competitiveness in the UK, related to workforce skills, access to finance and investment in infrastructure.
There is an argument that the UK's export performance through and since the crisis would have been far worse had the pound not depreciated sharply during the crisis. But a case can also be made that with firms' increasingly globalised supply chains, offshored production, and transactions in non-sterling markets, the modern economic environment in which firms operate is very different from standard textbook models.
The question facing policymakers and exporters alike is if the sharp depreciation in 2008 didn't support much of an export revival, how much of an impact will be felt from the recent strengthening of sterling?
It has clearly brought some benefits to the economy. An appreciation of the pound has reduced import costs across the board, not only driving down CPI inflation (in the process boosting households' purchasing power and thus supporting domestic demand) but also manufacturers' input costs, which were down 6% year on year in March. In addition, as a stronger exchange rate is an implied monetary tightening, this may push back the timing of a possible interest rate rise by the Bank of England, holding down firms' borrowing costs.
As things stand, the stronger pound has probably been more of a help than a hindrance to the recovery. But if sustained, it is possible that sterling strength could begin to threaten the process of rebalancing and weigh on overall activity, particularly once levels of pent-up demand start to fade. With UK economic data still robust and investors eyeing up the prospect of rising interest rates, the expectation—over the near term at least—is that sterling will continue to appreciate against both the dollar and the euro.