Shortly after the EU referendum, Sterling depreciated sharply against major currencies reflecting markets’ uncertainties on the UK’s future relationship with the EU. The last episode to date was Theresa May’s speech at the Conservative Party’s conference earlier this month. As markets’ fears of a “hard” Brexit grew further, Sterling hit a new 31-year low against the dollar ($1.219) and a 5-year low against the euro (EUR 1.109). This blog will provide a round-up of what the ups and downs of Sterling actually mean for UK manufacturers.
What do UK manufacturers think about Sterling depreciation?
When we asked companies about risks to their business plans for the year ahead at the start of 2016, exchange rate movements came on top of manufacturers’ concerns. At the start of this year, nearly one in two manufacturers (42%) considered exchange rate movements as a risk to their business plan, a record high in the survey’s four-year history. But this share leaped to 75% in the immediate aftermath of the EU referendum as Sterling lost 10% of its value against major currencies. This reminds us that manufacturers are concerned about both levels and volatility of the Sterling exchange rate.
Note: £ EER is the average effective exchange rate over the year (2005=100). £ volatility is measured as the standard deviation of daily changes in the Sterling exchange rate over the year.
Yet a weak exchange rate also provides opportunities for manufacturers. And these opportunities can materialize through more channels than people think.
So how do exchange rate movements actually affect manufacturers?
What does economic theory say?
Actually, the impact of exchange rate movements on UK companies is quiet complex (see chart).
The supply side
A Sterling depreciation pushes up import prices, thus leading to higher production costs – the magnitude of which will depend on firms’ reliance on imported raw materials and intermediate inputs. In the absence of market frictions, firms will pass through this surge to their clients in the form of higher output prices.
However, the pass through might not be immediate nor complete, which would ultimately squeeze firms’ profit margins. For example, a firm facing pressure from its clients or competitors in the supply chain would seek to delay and/or minimize the hike in output prices.
In the long term, once the exchange rate depreciation has passed through into higher output prices, CPI inflation rises, putting pressure on wages and resulting in second-round upward pressures on production costs.
The demand side
Export market. The theory suggests that a Sterling depreciation translates into lower export prices – the extent of this will depend on firms’ reaction to rising import costs as explained above and on the currency in which firms sell internationally. Depending on the sensitivity of foreign demand to export prices, overseas volume sales will move upward. Alternatively, should firms decide not to move export prices, margins on overseas sales will improve following a Sterling depreciation.
Domestic market.The rise in import prices means that locally produced goods become cheaper for UK consumers (import substitution effect), resulting in higher demand for domestic goods. However, the surge in CPI inflation may ultimately affect consumers’ disposable income and translate into lower aggregate consumption (wealth effect).
What changes have manufacturers seen so far?
1. What happened to input costs?
The pass through of the Sterling depreciation into input costs was relatively quick. In July, 31% of manufacturers had already seen a pickup in input costs, and more than half of them expected this change to occur in the next six months. Import-intensive industries were the most affected, with sectors such as rubber and plastics, chemicals and mechanical equipment showing the largest positive balances.
Producer prices data released by the ONS provided further evidence for this trend. In fact, input costs turned positive after two years of decline. The index surged by 4.1% in the year to July and then by 7.6% in the year to August.
2. How have manufacturers reacted in the domestic market?
The pass-through of the Sterling depreciation into output prices was not immediate as the trend in producer prices and CPI inflation has so far suggested. Indeed, manufacturers kept prices unchanged over the previous quarter, resulting in a significant squeeze in profit margins on domestic sales.
Looking ahead, manufacturers plan to increase output prices by the end of the year, which will provide some relief to profit margins on domestic sales. However, the pass-through is unlikely to be complete as profit margins continue to be under pressure in the last quarter of this year.
Note: dashed bars are expectations for 2016q4
Margin pressures on domestic sales are unequal across sectors as we highlighted in a previous blog. But most sectors expect margin pressures to ease slightly in 2016q4 as manufacturers start to pass through the increase in input costs to their clients, with non-metallic minerals being the only exception.
3. What about exports?
While exports of manufactured goods rose in the past two months at a monthly growth rate of +1.4% in August and +0.4% in July, it is far too early to conclude a Sterling-related impact. In fact, manufacturers have been reporting bright demand conditions in the international market so far this year, which is likely to have played a greater role in driving exports’ growth recently.
Movements in export prices are likely to affect profit margins on overseas sales in the short term however, as the surge in input costs is not completely passed through into higher export prices. As for domestic margins, negative balances are narrowing as manufacturers expect the pass-through to occur by the end of the year. Only three sectors (rubber and plastics, food and drink, transport) expect margin pressures on overseas sales to persist over 2016q4.
All in all, the exchange rate benefit more balanced than people think
Back in July, EEF EU referendum survey indicated that a net balance of only 6% of companies said that a persistently weak Sterling would have a positive impact on their business. The sector breakdown reflects quite well what movements in exchange rate mean for different sectors in terms of change in input costs, margin pressures and opportunities for increased export sales.