There’s been a lot of discussion on the impact of the appreciating pound for UK’s exporters. Reflecting the divergence between the economic fortunes of the UK and its largest trading partner, the Eurozone, the pound has appreciated by 12% to the euro since January 2010. In September 2014, the pound stood at 1.2637 to the euro, roughly around its 5-year peak on August 2012.
The consensus seems to be that a strong pound is hurting export-intensive industries. Standard economic theory supports this hypothesis – an appreciation of the domestic currency will make exports more expensive to foreign buyers. But in the modern economic era, isolating the effect of exchange rate movements on exports has become a far more complicated task.
An appreciation of the domestic currency makes input costs into production cheaper by lowering the cost of imported goods. This could potentially allow firms to absorb exchange rate movements into their mark-ups and minimise the damage from less competitive export pricing.
Why does all this matter?
The UK economic recovery has been heavily tilted on the consumption side of GDP growth. In fact, net trade has been a large negative contributor despite strong growth in the manufacturing sector. The failure of net trade to boost growth has been sighted as one of the primary reasons for the failure to rebalance the economy as well as inject some much needed cash to the Exchequer’s current account.
The most important cyclical factor for this is the weakness in key export markets and most of all the Eurozone, which accounts for roughly 50% of UK exports. However, another reason cited by exporters has been the sharp appreciation in the value of the pound.
We conducted a modelling exercise to tease out the macroeconomic effects of movements in the exchange rate under two scenarios. The benchmark for this modelling exercise is a 10% movement in the value of the Pound.
In the first scenario we appreciate the Pound by 10% relative to the Euro (£1 = €1.39) starting Q1 2015 and holding it constant up to Q4 2016. In the second scenario we depreciate the Pound by 10% relative to the Euro (£1 = €1.14) for the same period. We identify the impact of the Pound’s appreciation against GDP, inflation and a set of key trade indicators.
* All figures show difference from the baseline forecast on Q4 2016.
** Trade balance % GDP at Q4 2016.
Appreciation bad, depreciation good
The modelling exercise clearly shows that an appreciation of the Pound is detrimental to both GDP and net trade. By contrast, a depreciation of the Pound leads to a considerable increase in export volumes and a narrowing of the trade deficit. Inflation appears to only have a marginal effect on GDP and trade indicators under both scenarios.
The results also show that the impact is largely concentrated on the manufacturing/goods sector. This is consistent with the expectation that commoditised sectors which export goods are more price-sensitive and thus more vulnerable to currency fluctuations than say services exports.
But is this impact really uniform across exporters?
Our experience from UK manufacturing tells us that it is not. The impact of currency movements will largely depend on the type of exporting company and the industry it operates in. We have identified four broad groups of manufacturers based on how exchange rates might affect them:
- Price-sensitive: manufacturers in highly commoditised sectors are hurt the most from an appreciation in the pound (e.g. basic metals).
- Not price-sensitive: manufacturers in less commoditised sectors suffer more from volatility in exchange rates, which eat up their margins more than their export orders, rather than their direction (e.g. aerospace).
- Niche manufacturers: manufacturers who operate in niches produce products that are relatively price inelastic and face little competition on price – thus they are not affected by exchange rate movements (e.g. high-tech goods).
- Net importers: manufacturers who target the domestic market and import more than they export would benefit from an appreciation of the pound (e.g. food & drink).
So what’s the verdict?
The model has behaved according to expectations and in line with standard economic theory. An appreciation of the Pound would hurt GDP and net trade; and the goods/manufacturing sector disproportionately so. A depreciation of the Pound would have the exact opposite effects.
However, in reality the effect is much more heterogeneous and less straightforward. Whether an appreciation or depreciation will hurt manufacturers is contingent on the industry they operate in and the type of product they export. Thus, the macroeconomic impact of currency movements will largely depend on the industry composition of exporting firms in the economy.