Exchange Rate Folly: How The British Government Lost The Plot

Desmond Cohen

The collapse of Sterling’s foreign exchange rate since the Brexit referendum is on a scale we have not seen in many years and yet the government seems totally unconcerned. Indeed, in large part the fall is directly the result of government statements and actions. Some decline was predicted following the referendum but the rate seems now to be in free fall after recent declarations by a Government that it is intent on a ‘hard Brexit’. At least 44% of all UK trade is with the EU and access to this market can only be retained unless the UK accepts free movement of labour.

So it is unsurprising that, in these conditions of uncertainty, the exchange rate has collapsed. But the scale of the decline has been greater than anyone had predicted. Sterling has fallen sharply against the US$ to a level not seen since the 1980s and there have been similarly sharp falls against the euro. In these cases there are now predictions that the rates may fall to parity within the next few months. The overall effect of depreciation on this scale is to reduce real national income and overall living standards – the cost of imports is increased and export prices are lowered.

For many years the UK has been running a deficit on its current account. In the second quarter of 2016 this was no less than 5.9% of GDP and deficits on this scale have been common for many years. Of course, a country can only continue to run a large current account deficit if it either has large foreign exchange reserves – the UK doesn’t – or else it borrows extensively overseas.

And herein lies the first of the problems facing the UK government: How to generate the conditions favourable to continued foreign capital inflow so as to finance the huge current account deficit and at the same time have low domestic interest rates, when the value of sterling is in free fall.

The Bank of England could reverse its current interest rate strategy (low rates to sustain domestic demand) but any significant rise would create chaos given the level of secured (mortgage) and unsecured debt – much of it unfinanceable if rates were to rise. To finance that deficit by encouraging capital inflows through higher interest rates would add to the domestic deflationary pressures already brought by BREXIT, thus causing higher levels of unemployment and widening the fiscal deficit as automatic fiscal stabilisers kick in.

Economic Response

The government story repeated ad nauseam by Ministers is that the exchange rate fall will boost demand by encouraging exports. To a degree this may indeed happen – but with long lags and the scale of any general increase in demand is highly uncertain and probably not very large. Exports currently account for some 28% of UK GDP and since manufacturing output is now less than 15% of GDP the leverage that is possible through an expansion of the demand component considered sensitive to a falling exchange rate is relatively small. PLUS, there is a very significant import content of exports – estimated by the OECD as 23%. A large part of both UK manufacturing output and especially of exports is through chains of highly specialised inputs.

There will also be indirect effects on export costs deriving from domestic adjustments as the impact of the decline in the exchange rate feeds through into the economy. Imports are 30% of GDP and a fall of say 15% in the sterling exchange rate will add something like 5% to domestic costs of all food and other commodities, including fuel where increases in petrol and diesel prices have already been announced by suppliers.

In addition, if there is to be a rise in net exports then UK output has to become more competitive. But as we have seen the current account has been in steep deficit for many years, reflecting the general uncompetitiveness of the economy.

The ONS has just published data on comparative labour productivity which makes only too clear the gap between UK and its main competitors. In 2014 output per hour worked in Italy was 10% more, in the USA and France 30% more, in Germany 36% more. For the G7 countries the average productivity level was 18% more. This gap reflects low levels of investment per worker in the UK, low levels of investment in skills and especially low levels of R&D spend. In the latter case, the UK spends 1.7% of GDP whereas Germany spends 2.9% and the US 2.7%.

Skills imports

One factor that has made it possible for the UK economy to function more or less effectively has been the ability to draw on the international market for skills. There are key sectors which are totally dependent on recruitment of overseas labour, including health and social care, financial services, higher education and basic scientific research, construction and transport.

UK has since it joined the EU in 1973 become an important destination for direct investment – less because of the opportunities opened in the UK market and more because it was a base for exporting to the rest of the EU. The EU is now the largest market worldwide and yet the hard Brexit stance of ministers threatens access to the single market. British producers would, in that event, face the common external tariff which will make it more expensive to sell against competitors inside the EU.

The tariff plus the inevitable rise in import costs will erode much of any exchange rate benefit to UK-based producers. Unsurprisingly, then, a major car producer such as Nissan which sends most of its output to the EU could put all investment on hold. Fuji with a UK labour force of 14,000 has also voiced its dismay with the proposed exit from the EU. Overall, investment could be cut back and new direct investment flows reduced thus worsening the overall balance of payments.

The key dynamic sector for both employment growth and as a share of GDP for many years has been financial services. These now account for some 10% of GDP and are a major source of tax revenue. The growth of this sector has been largely determined by privileged access to the EU market together with extremely weak supervision by the British banking authorities. It seems evident from statements made by the EU that the current access to the EU under the so-called ‘EU passport’ for financial organisations in the UK will be discontinued and that the particular locational advantages of being in UK will disappear. Several important banks have already indicated that they are looking at relocating to Frankfurt or Paris.

Why Are We In This Mess?

The instability and decline of the exchange rate are creating major problems for all producers – and consumers as well. The government seems oblivious to the costs of its policy both now and in the medium to long term. There are clear conflicts of economic policy since interest rates have to be focused on the state of domestic demand/output and cannot be used for managing the exchange rate. In these circumstances and given the totally unrealistic policy on foreign trade it is inevitable that sterling will continue to fall against other currencies.

The changes in economic policy that are needed are self-evident: a clear statement that the UK will remain in the single market with all that that implies. There is undoubtedly scope for managing labour flows into the UK in a way that will meet EU regulations and this needs to be explored. Many EU countries in practice have regulations relating to employment and residence that effectively restrain migrant flows and these seem perfectly consistent with access to the single market.