Newspaper headlines this week read that the UK’s balance of trade deficit has widened to £34.8bn, the largest since 2010. And when you exclude services, the trade in goods deficit, at £119.9bn is the largest ever in nominal terms and is also likely to be the largest as a percentage of GDP.
So far so bad. But when you look a little closer, the picture is more mixed. The balance of trade deficit (i.e. on both goods and services) narrowed each quarter of 2014, although the monthly figure did widen in December 2014. In fact the trade in goods deficit increased substantially in December from £9.3bn to £10.2bn.
At first sight the widening of the trade deficit in December might seem surprising, given the dramatic drop in oil prices. Surely, with demand for oil being relatively inelastic, a large cut in oil prices should significantly reduce the expenditure on oil? In fact the reverse happened. The oil deficit in December increased from £598m to £940m. The reason is that oil importing companies have been stockpiling oil while low prices persist. Clearly, this is in anticipation that oil prices will rise again before too long. What we have seen, therefore, is a demand that is elastic in the short run, even though it is relatively inelastic in the medium run.
But the trade deficit is still large. Even when you strip out oil, the deficit in December still rose – from £8.7bn to £9.2bn. There are two main reasons for this deterioration.
The first is a strong pound. The sterling exchange rate index rose by 1.8% in December and a further 0.4% in January. With quantitative easing pushing down the value of the euro and loose monetary policies in China and Australia pushing down the value of their currencies, sterling is set to appreciate further.
The second is continuing weakness in the eurozone and a slowing of growth in some major developing countries, including China. This will continue to dampen the growth in UK exports.
But what of the overall current account? Figures are at present available only up to 2014 Q3, but the picture is bleak (see the chart). As the ONS states:
The current account deficit widened in Q3 2014, to 6.0% of nominal Gross Domestic Product GDP, representing the joint largest deficit since Office for National Statistics (ONS) records began in 1955.
This deterioration in performance can be partly attributed to the recent weakness in the primary income balance [see]. This also reached a record deficit in Q3 2014 of 2.8% of nominal GDP; a figure that can be primarily attributed to a fall in UK residents’ earnings from investment abroad, and broadly stable foreign resident earnings on their investments in the UK
The primary income account captures income flows into and out of the UK economy, as opposed to current transfers (secondary income) from taxes, grants, etc. The large deficit reflects a decline in the holding by UK residents of foreign assets from 92% of GDP in 2008 to 67% by the end of 2014. This, in turn, reflects the poorer rate of return on many of these assets. By contrast, the holdings of UK assets by foreign residents has increased. They have been earning a higher rate of return on these assets than UK residents have on foreign assets. And so, despite UK interest rates having fallen, as the quote above says, foreign residents’ earnings on their holding of UK assets has remained broadly stable.
Articles
UK trade deficit last year widest since 2010 BBC News (6/2/15)
UK’s trade deficit widens to 2010 high as consumers take advantage of falling oil The Telegraph, Peter Spence (6/2/15)
UK trade deficit widens to four-year high The Guardian, Katie Allen (6/2/15)
UK trade deficit hits four-year high Financial Times, Ferdinando Giugliano (6/2/15)
Data
Balance of Payments ONS (topic link)
Summary: UK Trade, December 2014 ONS (6/2/15)
Current account, income balance and net international investment position ONS (23/1/15)
Pink Book – Tables ONS
Questions
- Distinguish between he current account, the capital account and the financial account of the balance of payments.
- If the overall balance of payments must, by definition, balance, why does it matter if the following are in deficit: (a) trade in goods; (b) the current account; (b) income flows?
- What would cause the balance of trade deficit to narrow?
- Discuss what policies the government could pursue to reduce the size of the current account deficit? Distinguish between demand-side and supply-side policies.
- Why has the sterling exchange rate index been appreciating in recent months?
- What do you think is likely to happen to the sterling exchange rate index in the coming months? Explain.
One effect of an expansionary monetary policy is a depreciation of the exchange rate. Take the case of countries using a combination of a reduction in central bank interest rates and quantitative easing (QE). A fall in interest rates will encourage an outflow of finance; and part of the money created through quantitative easing will be used to purchase foreign assets. Both create an increased demand for foreign currencies and drive down the exchange rate.
The latest case of expansionary monetary policy is that employed by the ECB. After months of promising to ‘do whatever it takes’ and taking various steps towards full QE, the ECB finally announced a large-scale QE programme on 22 January 2015.
With people increasingly predicting QE and with the ECB reducing interest rates, so the euro depreciated. Between March 2014 and 21 January 2015, the euro depreciated by 20.2% against the dollar and the euro exchange rate index depreciated by 9.7%. With the announced programme of QE being somewhat larger than markets expected, in the week following the announcement the euro fell a further 2.3% against the dollar, and the euro exchange rate index also fell by 2.3%. The euro is now at its lowest level against the US dollar since April 2003 (see chart).
The depreciation of the euro will be welcome news for eurozone exporters. It makes their exports cheaper in foreign currency terms and thus makes their exports more competitive. Similarly Japanese exporters were helped by the depreciation of the yen following the announcement on 31 October 2014 by the Bank of Japan of an increase in its own QE programme. The yen has depreciated by 7.7% against the dollar since then.
But every currency cannot depreciate against other currencies simultaneously. With any bilateral exchange rate, the depreciation of one currency represents an appreciation of the other. So just as the euro and yen have depreciated against the dollar, the dollar has appreciated against the euro and yen. This has made US goods less competitive relative to eurozone and Japanese goods.
The danger is that currency wars will result, with monetary policy being used in various countries to achieve competitive depreciations. Already, the Swiss have been forced, on 15 January, to remove the cap with the euro at SF1 – €0.833. Since then the Swiss franc has appreciated by some 15% to around SF1 – €0.96. Will the Swiss now be forced to relax their monetary policy?
The Danish and Canadian central banks have cut their interest rates, hoping to stem an appreciation of their currencies. On 28 January, the Monetary Authority of Singapore sold Singapore dollars to engineer a depreciation. The Singapore dollar duly fell by the most in over four years.
But are these policies simply beggar-my-neighbour policies? Is it a zero-sum game, where the gains to the countries with depreciating currencies are exactly offset by losses to the those with appreciating ones? Or is there a net gain from overall looser monetary policy at a time of sluggish growth? Or is there a net loss from greater currency volatility, which will create greater uncertainty and dampen cross-border investment? The following article explore the issues.
Articles
Massive Devaluation of the Euro Seeking Alpha, Sagar Joshi (26/1/15)
Devaluation and discord as the world’s currencies quietly go to war The Observer (25/1/15)
Why is dollar strong vs. 18 trillion of USA’s debt? Pravda, Lyuba Lulko (26/1/15)
Central Bankers Ramp Up Currency Wars Wall Street Journal, Anjani Trivedi, Josie Cox and Carolyn Cui (28/1/15)
The Raging Currency Wars Across Europe The Market Oracle, Gary_Dorsch (29/1/15)
Why ECB action is likely to stoke global currency wars Financial Times, Ralph Atkins (22/1/15)
Euro slides as ECB launches QE Financial Times (22/1/15)
Will Australia join the Currency Wars? The Daily Reckoning, Australia, Greg Canavan (23/1/15)
Australia’s central bank cuts rates to record low; currency plunges and stocks spike The Telegraph (3/2/15)
Singapore loosens monetary policy Financial Times, Jeremy Grant (28/1/15)
Currency Wars Have a Nuclear Option Bloomberg, Mark Gilbert (12/2/15)
Questions
- Explain how quantitative easing results in depreciation. What determines the size of the depreciation?
- How is the USA likely to react to an appreciation of the dollar?
- In the UK, who will benefit and who will lose from the depreciation of the euro?
- What are the global benefits and costs of a round of competitive depreciations?
- How does the size of the financial account of the balance of payments affect the size of a depreciation resulting from QE?
- What determines a country’s exchange-rate elasticity of demand for exports? How does this elasticity of demand affect the size of changes in the current account of the balance of payments following a depreciation?
- Might depreciation of their currencies reduce countries’ commitment to achieving structural reforms? Or might it ‘buy them time’ to allow them to introduce such reforms in a more carefully planned way and for such reforms to take effect? Discuss.
The latest balance of payments data for the UK show that in the final two quarters of 2013 the current account deficit as a percentage of GDP was the highest ever recorded. In quarter 3 it was 5.6% of GDP and in quarter 4 it was 5.4% of GDP. The previous highest quarterly figures were 5.3% in 1988 Q4 and 5.2% in 1989 Q3. The average current account deficit from 1960 to 2013 has been 1.1% of GDP and from 1980 to 2013 has been 1.6% of GDP.
The current account has four major components: the balance on goods, the balance on services, the balance on current transfers and the balance on income flows (e.g. investment income). The chart below shows the annual balances of each of these components, plus the overall current account balance, from 1960 to 2013.
There are large differences in the balances of these four and the differences seem to be widening. (Click here for a PowerPoint of the chart.)
Traditionally the balance on goods has been negative. In 2013 Q3 the deficit on goods reached a record 7.3% of GDP. It fell back somewhat in Q4 to 6.5%, still significantly above the average since 2000 of 5.5%. With the economy still recovering slowly, it would normally be expected that the trade deficit would be low. However, the high exchange rate has made it difficult for UK exporters to compete. Also with consumer confidence returning, imports are rising, again boosted by the high exchange rate, which makes imports cheaper.
The services balance, by contrast, is typically in surplus. In the final two quarters of 2013, the surpluses were 4.9% and 5.1% of GDP respectively. These compare with an average of 3.3% since 2000. It seems that the service sector, which includes banking, insurance, consultancy, advertising, accountancy, law, etc., is much more able to compete in a global environment.
The balance of current transfers to and from such bodies as the EU and UN have traditionally been negative, although as a proportion of GDP this has gradually widened in recent years. In 2013 the deficit was 1.7% compared with an average of 1.0% since 2000.
The most dramatic change has been in income flows and particularly those from investment. Before the crash in late 2008, the returns to many of the risky investments abroad made by UK financial institutions were very high. Income flows in the 12 months 2007 Q4 to 2008 Q3 averaged a surplus of 2.8% of GDP. They stayed positive, albeit at lower levels, until 2012 Q1, but then became negative as UK institutions reduced their exposure to overseas investments and as earnings in the UK by overseas investors increased. In the last two quarters of 2013, the deficits on income flows were 1.4% and 2.5% of GDP respectively.
How do these figures accord with the Chancellor’s desire to rebalance the economy towards exports? In terms of services, the export performance is good. In terms of goods, however, exports actually fell in the last two quarters from £78.4bn to £74.8bn. Although imports fell too in the final quarter, there is a danger that, with recovery and a high pound, these could begin to rise rapidly
So should the Bank of England attempt to bring the sterling exchange rate down? After all, the exchange rate index has risen from 79.1 in March 2013 to 85.9 in February 2014 (an appreciation of 8.6%). But if it did want to do so, what could it do? The traditional methods of reducing Bank rate and increasing the money supply are not open to it at the present time: Bank rate, at 0.5%, is already about as low as it could go and the Bank has ruled out any further quantitative easing.
The articles consider the latest balance of payments figures and their implications for the economy and for economic policy
Articles
UK current account deficit far bigger than forecast The Guardian, Katie Allen (28/3/14)
UK current account deficit near record high at £22.4bn BBC News (28/3/14)
UK current account gap second widest on record The Telegraph, Szu Ping Chan (28/3/14)
When will the UK pay its way? BBC News, Robert Peston (28/3/14)
Current account deficit crisis creeping up on UK can no longer be ignored The Guardian, Larry Elliott (30/3/14)
Data
Balance of Payments, Q4 and annual 2013 ONS (28/3/14)
Statistical Interactive Database – interest & exchange rates data Bank of England
Questions
- If the current account is in deficit, how is the overall balance of payments in balance (i.e. is in neither deficit nor surplus)?
- If the current account is in record deficit, why has sterling appreciated over recent months? What effect is this appreciation likely to have on the balance on trade in goods and services?
- Why has the balance on investment income deteriorated? In what ways could this be seen as a ‘good thing’?
- To what extent do the balance of payments figures show a rebalancing of the economy in the way the Chancellor would like?
- What could the Bank of England do to bring about a depreciation of sterling?
- What would be the benefits and costs of a depreciation of sterling?
- Why do investors overseas seem so willing to lend to the UK, thereby producing a large surplus on the financial account?
Compared with pre-financial crisis levels, the British pound is significantly weaker when measured against a basket of foreign currencies. In this blog we provide a further update of Appreciating a depreciating pound which was published back in early December 2012. The significance of the depreciation should be seen in the context of the UK as an open, island-economy where the ratio of exports to GDP in 2012 was close to 32%.
The competitiveness of our exports is, in part, affected by the exchange rate. Floating exchange rates are notoriously volatile. For example, some of the articles below show how sensitive the British pound can be latest news on the economy. However, since the autumn of 2007 we have observed a significant depreciation of the UK exchange rate. A depreciation helps to make our exports more competitive abroad and can potentially boost aggregate demand.
Rather than simply focus on bilateral exchange rates and so at the British pound separately against other foreign currencies, we can estimate an average exchange rate against a whole bundle of currencies. The average rate is calculated by weighting the individual exchange rates by the amount of trade between Britain and the other countries. This trade-weighted exchange rate is known as the effective exchange rate.
In analysing the competitiveness of the exchange rate, we can go one step further and adjust for the average (domestic currency) price of our exports relative to the average (foreign currency) price of those goods we import. Therefore, as well as the nominal (actual) effective exchange rate we can calculate a real effective exchange rate. If the average price of our exports rises relative to the average price of imports, the real effective exchange rate rises relative to the nominal rate. It means that we are able to obtain a larger volume of imports from selling a given volume of exports.
The chart shows the nominal (actual) and real effective exchange rate for the British pound since 2001. The chart shows clearly how from the autumn of 2007 the effective exchange rate fell sharply both in nominal and real terms.
Over the period from July 2007 to January 2009 the nominal effective exchange rate fell by 26.8 per cent while the real effective exchange rate fell by 26.6 per cent. In other words, the British pound depreciated more than one-quarter over an 18-month period. In comparison, the American dollar rose by 5.3 per cent in nominal terms and by 1.9 per cent in real terms. (Click here to download a PowerPoint of the chart.)
If we move the clock forward, we observe an appreciation of the British pound between July 2011 and September 2012. Over this period, the British pound appreciated by 7.0 per cent in nominal terms and by 7.3 per cent in real terms. However, this appreciation had effectively been wiped-out when by March 2013 the nominal rate had depreciated by 6.1 per cent and by 5.6 per cent in real terms. Subsequently, there has been a slight appreciation once more. As of September, the nominal rate had risen by 4.5 per cent and the real rate by 4.8 per cent.
While, as recent figures help to demonstrate, the British pound continues on its roller-coaster ride, there has been a very marked depreciation since the giddy-days prior to the financial crisis. The facts show that when comparing the effective exchange rate in September 2013 with July 2007 the British pound was 21.8 per cent lower in nominal terms and 18.3 per cent in real terms. Over the same period, the US dollar, for example, was only 1.3 per cent lower in nominal terms and 6.1 per cent in real terms. This constitutes a major competitive boost for our exporters. Nonetheless, there remain uncertainty about just how much British exporters can take advantage of this, the amount that it will boost British growth and the impact it will make on the country’s chronic balance of trade deficit in goods which was close to 7 per cent of GDP in 2012.
Data
Statistical Interactive Database – interest and exchange rate rates data Bank of England
BIS effective exchange rate indices Bank for International Settlements
Market Data: Currencies BBC News
Recent Articles
Unexpected drop in factory output dents sterling Reuters UK, Jessica Mortimer (9/10/13)
Pound Forecasts Soar as BOE’s Carney Signals Shift: Currencies Bloombeg, Lukanyo Mnyanda and Emma Charlton (19/10/13)
Pound Advances as U.K. Financial Optimism Improves; Gilts Rise Bloombeg, Emma Charlton (7/10/13)
Re-balancing and the re-industrialisation of Britain BBC News, Linda Yueh (13/10/13)
Signs of recovery abound but with little consensus on future course Financial Times, Chris Giles and Sarah O’Connor (31/10/13)
Previous Articles
Pound depreciates Vs dollar to lowest level since Aug 16 Bloomberg, Emma Charlton (5/2/13)
Pound advances against euro on Italy speculation; Gilts decline Bloomberg, Lucy Meakin and David Goodman Alice Ross (4/3/13)
Pounding of sterling risks a currency war Scotland on Sunday, Bill Jamieson (17/2/13)
Credit ratings, the pound, currency movements and you BBC News, Kevin Peachey (25/2/13)
The Bank of England can’t just go on doing down the pound Telegraph, Jeremy Warner (21/2/13)
Sterling will continue to go down BBC News, Jim Rogers (25/2/13)
Questions
- Explain how the foreign demand for goods and assets generates a demand for British pounds. How will this demand be affected by the foreign currency price of the British pound, i.e. the number of foreign currency units per £1?
- Explain how the demand by British residents for foreign goods and assets generates a supply of British pounds. How will this supply be affected by the foreign currency price of the British pound, i.e. the number of foreign currency units per £1?
- What factors are likely to shift the demand and supply curves for British pounds on the foreign exchange markets?
- Illustrate the effect of a decrease in the demand for British goods and assets on the exchange rate (i.e. the foreign currency price of the British pound) using a demand-supply diagram.
- What is the difference between a nominal and a real effective exchange rate? Which of these is a better indicator of the competitiveness of our country’s exports?
- What factors are likely to have caused the depreciation of the British pound since 2007?
- What is meant by a deficit on the balance of trade in goods?
- What relationship exists between the demand and supply of currencies on the foreign exchange markets and the balance of payments?
In an interview with the Yorkshire Post, Mark Carney, Governor of the Bank of England, said that under current circumstances he did not feel that further quantitative easing was justified. He said:
My personal view is, given the recovery has strengthened and broadened, I don’t see a case for quantitative easing and I have not supported it.
In response to his speech, the pound strengthened against the dollar. It appreciated by just over 1 cent, or 0.7%. But why should the likelihood of no further quantitative easing lead to a strengthening of the pound?
The answer lies with people’s anticipation of future interest rates. If there is no further increase in money supply through QE, interest rates are likely to rise as the economy recovers and thus the demand for money rises. A rise in interest rates, in turn, is likely to lead to an inflow of finance into the country, thereby boosting the financial account of the balance of payments. The increased demand for sterling will tend to drive up the exchange rate.
However, an increase in aggregate demand will result in an increase in imports and a likely increase in the balance of trade deficit. Indeed, in July (the latest figures available) the balance of trade deficit rose to £3.085bn from £1.256bn in June. As recovery continues, the balance of trade deficit is likely to deteriorate further. Other things being equal, this would lead to a depreciation of the pound.
So if the pound appreciates, this suggests that the effect on the financial account is bigger than the effect on the current account – or is anticipated to be so. In fact, given the huge volumes of short-term capital that move across the foreign exchanges each day, financial account effects of interest rate changes – actual or anticipated – generally outweigh current account effects.
Articles
Yorkshire can reap benefits from turnaround says Mark Carney Yorkshire Post (27/9/13)
Sterling Jumps as BOE Chief Signals No More Bond Buying Wall Street Journal, Nick Cawley and Jason Douglas (27/9/13)
Carney’s Northern Exposure Sends Sterling Soaring Wall Street Journal, David Cottle (27/9/13)
Pound Gains as Carney Sees No Case for QE, Confidence Improves Bloomberg, Anchalee Worrachate & David Goodman (28/9/13)
Exchange Rate Bounces as Strong UK Data Supports Sterling FCF (Future Currency Forecast), Laura Parsons (30/9/13)
Currency briefing: What if the pound sterling has been overbought? iNVEZZ, Tsvyata Petkova (30/9/13)
Pound rises after Carney rejects increasing QE BBC News (27/9/13)
Pound Rises for Fourth Day Versus Euro on Housing, Mortgage Data Bloomberg, Emma Charlton (30/9/13)
Data
$ per £ exchange rate (latest month) XE (You can access other periods and currencies)
Effective exchange rate indices (nominal and real) Bank for International Settlements
Balance of Payments, Q2 2013 Dataset ONS
Questions
- Explain how quantitative easing affects exchange rates.
- What is happening concerning quantitative easing in the USA? How is this likely to affect the exchange rate of the US dollar to sterling; other currencies to sterling?
- Why may an increase in the balance of trade deficit lead directly to an appreciation of the exchange rate?
- Why is an anticipation of a policy change likely to have more of an effect on exchange rates than the actual policy change itself? Why, indeed, may a policy change have the reverse effect once it is implemented?
- Under what circumstances may speculation against exchange rate changes be (a) stabilising; (b) destabilising?
- How is quantitative easing (or an anticipation of it) likely to affect each of the main components of the current and financial accounts of the balance of payments?
- For what reasons might sterling have been ‘overbought’ and hence be overvalued?
- What is meant by the real exchange rate (REER)? Why may reference to the REER suggest that sterling is not currently overvalued?