UK currency has appreciated, is this good or bad ?
A Strong Sterling Doesn’t Mean Lower UK Growth
By: Ashley Kindergan, Published: February 20, 2014
If you accept the textbook explanation of what happens when a country’s currency appreciates, the United Kingdom would have every right to be nervous. The pound has appreciated some 8 percent over last year both in trade-weighted terms and against the dollar, and buys roughly 5 percent more euros than it did a year ago. And such a sharp move usually portends bad economic news: net trade should suffer, bringing GDP growth down with it.
And the pound is probably headed even higher yet. Last week, Credit Suisse’s foreign exchange strategists upped their forecasts for the British currency over the next three months. Instead of trading for €1.23/$1.61, they now expect a pound to be worth €1.27/$1.66 by mid-May. Imports should increase as a percentage of GDP as the pound gets stronger. If it appreciates by 10 percent over the next five years, Credit Suisse’s European Economics team thinks imports will rise by 0.8 percent as a share of GDP over the same period. That, in turn, would shave a little less than 0.2 percent from GDP growth each year.
But it’s not all bad news. Because globalization truly is a powerful master – and this time, a somewhat helpful one. Because British manufacturing firms now source more of their inputs from overseas than they once did, a strengthening sterling does not threaten British economic growth as much as it once would have.
In 1992, 45 percent of British manufacturing industries got at least 80 percent of the goods in their supply chain from within the country. By 2011, only 15 percent did so. The result: British firms’ input costs should fall when they use a stronger currency to buy raw materials from offshore manufacturers. Considered in that light, the argument that a stronger currency makes a country’s exports less competitive isn’t quite as straightforward as it used to be. “If substantial parts of U.K. production have been moved outside of the U.K…. an appreciation of sterling would present less of a headwind to exports,” Credit Suisse economists Neville Hill and Steven Bryce wrote in a recent note called “Poundstretcher.”
The phenomenon is not uniquely British; it could also apply in countries such as the U.S. and Japan, where a good chunk of manufacturing has moved offshore. Here’s the shocker, though: A stronger currency may actually increase economic growth in the U.K. over the next two to three years, Hill and Bryce suggest.
The root of their argument lies in the fact that a shift in favor of imports should keep a lid on inflation. (The whole idea, after all, is that domestic consumers are switching to lower-priced goods.) That, in turn, would give real household income a boost and encourage spending. And greater consumer demand as a result of low inflation should make up for any trade-related GDP losses due to a stronger pound, Credit Suisse says. “Household real incomes will benefit from lower inflation more than otherwise for two or three years, while the impact of a loss of ‘competitiveness’ on net trade is likely to take effect with a much longer lag,” the economists wrote.
It’s important to keep in mind that the pound’s current strength reflects the remarkable recovery the British economy has enjoyed over the last two years. GDP grew by 1.9 percent in 2013, the most since 2007 and a far cry from the 0.2 percent increase in economic output in 2012. This year, Credit Suisse expects the economy to expand 2.8 percent. Two years ago, the unemployment rate was 8.4 percent. Today it’s 7.2 percent. British manufacturers reported an all-time high level of confidence in the latest quarterly survey from the British Chamber of Commerce, which covered the last quarter of 2013. Service industry business leaders, too, were more optimistic than at any time since 2007.
The question market participants have been asking themselves lately, however, is whether the Bank of England might soon spoil the party by hiking policy interest rates from their current level of 0.5 percent. This week, the central bank overhauled its forward guidance to address that speculation, laying out seven bullet points that would make a rate increase appropriate. They’re now taking a “less quantitative” approach, as Credit Suisse put it, than before.
The old guidance, for example, said the central bank would consider raising rates once unemployment dipped below 7 percent, a threshold it has very nearly crossed. The new guidance, on the other hand, contains an argument that unemployment data does not adequately reflect the slack that still exists in the economy, which the central bank estimates could be worth between 1 and 1.5 percent of GDP. Indeed, despite healthy GDP growth, U.K. wages rose just 0.9 percent in the three months to November. Not only that, nearly 20 percent of part-time employees say they would like to find more work – nearly the same level as in the depths of the recession.
Still, Credit Suisse’s European economists currently expect the Bank of England to raise rates by 0.5 percent next year, with the first hike coming in the first quarter of 2015. And thanks to the way international supply chains have changed the implications of a strong currency, a rallying sterling won’t do much to push that timeline back.