Sterling slide no panacea (continued)
Simon Ward
3 Comments
Trade figures for January released today show little evidence of the economic benefits promised by the many advocates of exchange rate devaluation.
Contrary to the script, net exports appear to be exerting a drag on the economy in early 2009. Excluding oil and erratic items, export volumes in January were 8% below their fourth-quarter level versus a 5% decline in imports.
Meanwhile, manufactured import prices climbed a further 1% in January to stand 14% higher than a year before. Ongoing sterling weakness suggests the annual rate of change will remain in double-digits – see chart. As argued previously, the import price surge has lifted underlying inflation, thereby partly offsetting the boost to real incomes from lower energy prices and the VAT cut.
The weaker exchange rate may also have worsened the credit crunch by encouraging foreigners to reduce their sterling bank deposits and eroding banks’ capital ratios by inflating the sterling value of their foreign currency assets. Foreign net lending in sterling to UK-based banks fell by £63 billion between August and January. Credit constraints may have prevented some exporters from taking full advantage of the falling currency.
Sterling has weakened again following last week’s MPC decision to embark on “quantitative easing”. While this policy change is warranted, it carries inflationary risks from a possible further large fall in the exchange rate. These risks would have been reduced by smaller interest rate cuts, greater fiscal discipline and less “talking down” of the currency by policy-makers.
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Reader Comments (3)
Did anybody say it was a panacea? This is surely a straw man. It is better than the alternative.
I disagree that it is better than the alternative. By reducing domestic purchasing power and exacerbating the banking crisis, the fall in sterling has been negative for the economy.
Official encouragement of currency depreciation has been reminiscent of Japan’s attempt to reflate its economy via a lower exchange rate in the late 1990s. This worsened a credit crunch by forcing capital-constrained banks to cut back domestic lending to compensate for a higher yen value of their foreign assets.
The policy even failed to stimulate trade – the yen’s depreciation helped to topple other Asian currencies and resulting deep recessions damaged Japanese exports. Similarly, sterling’s plunge may have contributed to the Eastern European currency crisis and pressure for devaluation elsewhere.
I don't see any deliberate sterling policy. The currency does what it does. When I talk about the costs of the alternative, I include, of course, the costs of trying, vainly, to stop it falling. That would presumably include higher interest rates.
In the longer run, the recovery of the UK must include a substantial rise in net exports. That certainly required a fall in what I have long considered a grossly overvalued real exchange rate. So this is, beyond doubt, a move towards equilibrium. Obviously, its effects will take time to work through.
I do not think it is the responsibility of the UK to consider the impact on the central and eastern European countries that have made absolutely classic macroeconomic policy errors, particularly encouraging very large-scale foreign currency borrowing.