The UK’s balance on trade continues to be sharply in deficit. At the same time, both manufacturing and overall production are still well below their pre-crisis levels. What is more, with a sterling exchange rate that has appreciated substantially over recent months, UK exports are at an increasing price disadvantage. The hoped-for re-balancing of the economy from debt-financed consumption to investment and exports has not occurred. Investment in the UK remains low relative to that in other major economies (see).
But other developments in the global economy are working in the UK’s favour.
Manufacturing globally is becoming more capital intensive, which reduces the comparative advantage of developing countries with low labour costs.
At the same time, the dividing line between manufacturing and services is becoming more blurred. Manufacturers in developing countries may still produce parts, such as chips or engines, but the design, marketing and sales of the products may take place in developed countries, such as the UK. Indeed, as products become more sophisticated, an increasing amount of value added may occur in developed countries.
The UK may be particularly well-placed in this regard. It can provide many high-end services in IT, business support and financial services to international manufacturers. It may have a comparative advantage in idea-intensive production.
Finally with a higher exchange rate, the UK’s terms of trade have been improving. The downside is that it makes UK exports more expensive in foreign currency terms, but it also makes commodity prices cheaper, which have already fallen in dollar terms, and also the prices of imported component parts. This helps offset the effect of the appreciation of the exchange rate on exports.
The following article by Jeremy Warner considers whether, despite its poor performance in traditional manufacturing, the UK might have hit an economic ‘sweet spot’ in its trade position.
Article
Unbalanced but lucky, Britain hits an economic sweet spot The Telegraph, Jeremy Warner (8/9/15)
Data
UK Trade (Excel file) ONS (9/9/15)
(See, for example, Worksheet 1. You can search for longer series using Google advanced search, putting www.ons.gov.uk in the ‘site or domaine’ box and searching for a particular series, using the series identifier found at the top of each column in the Excel file, such as BOKI for balance on trade in goods.)
Exchange rate data Bank of England Statistical Interactive Database
Questions
- Explain the difference between the balance on trade, the balance on trade in goods and the balance of payments on current account.
- Why has the UK not experienced a re-balancing of the economy as hope for by the Chancellor of the Exchequer, amongst others?
- What is meant by the ‘terms of trade’?
- What would cause an ‘improvement’ in the terms of trade?
- Are the UK’s terms of trade likely to move in the UK’s favour in the coming months? Explain.
- What current factors are mitigating against a recovery of UK manufacturing exports?
- Is de-industrialisation necessarily a ‘bad thing’?
- Does the development of new capital-intensive technologies in manufacturing mean that the UK could become a net exporter of manufactures? Explain why or why not.
The mood has changed in international markets. Investors are becoming more pessimistic about recovery in the world economy and of the likely direction of share prices. Concern has centred on the Chinese economy. Forecasts are for slower Chinese growth (but still around 5 to 7 per cent) and worries centre on the impact of this on the demand for other countries’ exports.
The Chinese stock market has been undergoing turmoil over the past few weeks, and this has added to jitters on other stock markets around the world. Between the 5th and 24th of August, the FTSE 100 fell by 12.6%, from 6752 to 5898; the German DAX fell by 17.1% from 11,636 to 9648 and the US DOW Jones by 10.7% from 17,546 to 15,666. Although markets have recovered somewhat since, they are very volatile and well below their peaks earlier this year.
But are investors right to be worried? Will a ‘contagion’ spread from China to the rest of the world, and especially to its major suppliers of raw materials, such as Australia, and manufactured exports, such as the USA and Germany? Will other south-east Asian countries continue to slow? Will worries lead to continued falls in stock markets as pessimism becomes more entrenched? Will this then impact on the real economy and lead then to even further falls in share prices and further falls in aggregate demand?
Or will the mood of pessimism evaporate as the Chinese economy continues to grow, albeit at a slightly slower rate? Indeed, will the Chinese authorities introduce further stimulus measures (see the News items What a devalued yuan means to the rest of the world and The Shanghai Stock Exchange: a burst bubble?), such as significant quantitative easing (QE)? Has the current slowing in China been caused, at least in part, by a lack of expansion of the monetary base – an issue that the Chinese central bank may well address?
Will other central banks, such as the Fed and the Bank of England, delay interest rate rises? Will the huge QE programme by the ECB, which is scheduled to continue at €60 billion until at least September 2016, give a significant boost to recovery in Europe and beyond?
The following articles explore these questions.
Articles
The Guardian view on China’s meltdown: the end of a flawed globalisation The Guardian, Editorial (1/9/15)
Central banks can do nothing more to insulate us from the Asian winter The Guardian, Business leader (6/9/15)
Where are Asia’s economies heading BBC News, Karishma Vaswani (4/9/15)
How China’s cash injections add up to quantitative squeezing The Economist (7/9/14)
Nouriel Roubini dismisses China scare as false alarm, stuns with optimism The Telegraph, Ambrose Evans-Pritchard (4/9/15)
Markets Are Too Pessimistic About Chinese Growth Bloomberg, Nouriel Roubini (4/9/15)
Data
World Economic Outlook databases IMF: see, for example, data on China, including GDP growth forecasts.
Market Data Yahoo: see, for example, FTSE 100 data.
Questions
- How do open-market operations work? Why may QE be described as an extreme form of open-market operations?
- Examine whether or not the Chinese authorities have been engaging in monetary expansion or monetary tightening.
- Is an expansion of the monetary base necessary for there to be a growth in broad money?
- Why might the process of globalisation over the past 20 or so years be described a ‘flawed’?
- Why have Chinese stock markets been so volatile in recent weeks? How seriously should investors elsewhere take the large falls in share prices on the Chinese markets?
- Would it be fair to describe the Chinese economy as ‘unstable, unbalanced, uncoordinated and unsustainable’?
- What is the outlook over the next couple of years for Asian economies? Explain.
- For what reasons might stock markets have overshot in a downward direction?
On August 11th, China devalued its currency, the yuan, by 1.9%. The next day it devalued it by a further 1.6% and on the next day by a further 1.1%. Even though the total devaluation was relatively small, especially given a much bigger revaluation over the previous three years (see chart below), traders in world markets greeted the news with considerable pessimism. Stock markets around the world fell. For example, the US Dow Jones was down by 1.1%, the FTSE 100 was down by 2.5% and the German DAX by 5.8%.
There are three major concerns of investors about the devaluation. The first is that a weaker yuan will make other countries’ exports more expensive in China, thereby making it harder to export to China. At the same time Chinese imports into the rest of the world will be cheaper, thereby making it harder for domestic producers to compete with Chinese imports.
The second is that cheaper Chinese imports will put downward pressure on prices at a time when inflation rates in the major economies are already below target rates. The fear of deflation has not gone away and this further deflationary twist will intensify such fears and possibly dampen demand.
The third is that the devaluation is taken as a sign that the Chinese authorities are worried about a slowing Chinese economy and are using the devaluation to boost Chinese exports. The rapidly expanding Chinese economy has been one of the major motors of the global economy in recent years and hence a slowing Chinese economy is cause for serious concern at a time when the global economy is still only very slowly recovering from the shock of the financial crisis of 2007–8
But just how worried should the rest of the world be about the falling yuan? And will it continue to fall, or could this be seen as a ‘one-off’ correction? What effect will it have on the macroeconomic policies of the USA, the eurozone and other major countries/regions? The following articles analyse Chinese policy towards its currency and the implications for the rest of the world.
China weakens yuan for a third straight day on Thursday CNBC, Nyshka Chandran (13/8/15)
Markets reel as investors fear worst of Chinese slowdown is yet to come The Telegraph, Peter Spence (12/8/15)
China cannot risk the global chaos of currency devaluation The Telegraph, Ambrose Evans-Pritchard (12/8/15)
Beware a China crisis that could crash down on us all The Telegraph, Liam Halligan (15/8/15)
The curious case of China’s currency The Economist, Buttonwood’s notebook (11/8/15)
China’s yuan currency falls for a second day BBC News (12/8/15)
China slowdown forces devaluation BBC News, Robert Peston (11/8/15)
What the yuan devaluation means around the world BBC News, Lerato Mbele, Daniel Gallas and Yogita Limaye (12/8/15)
China allows yuan currency to drop for third day BBC News, various reporters (13/8/15)
The Guardian view on global currencies: it’s the economy, stupid The Guardian, Editorial (14/8/15)
China’s currency gambit and Labour’s debate about quantitative easing: old and new ways to cope with economic crisis The Guardian, Paul Mason (16/8/15)
Questions
- By what percentages have the nominal and real yuan exchange rate indices appreciated since the beginning of 2011? Use data from the Bank for International Settlements.
- Explain the difference between nominal and real exchange rate indices.
- Compare the changes in the yuan exchange rate indices with that of the yuan/dollar exchange rate (see Bank of England Interactive Database). Explain the difference.
- How is the yuan exchange rate with other currencies determined?
- How have the Chinese authorities engineered a devaluation of the yuan? To what extent could it be described as a ‘depreciation’ rather than a ‘devaluation’?
- Why have world stock markets reacted so negatively to the devaluation?
- Why, in global terms, is the devaluation described as deflationary?
- How much should the rest of the world be worried by the devaluation of the yuan?
- Explain the statement by Robert Peston that ‘Beijing has done the monetary tightening that arguably the US economy needs’.
- Comment on the following statement by Stephen King of HSBC (see the second Telegraph article below): ‘The world economy is sailing across the ocean without any lifeboats to use in case of emergency.’
It was argued in an earlier blog on the Greek debt crisis that a deus ex machina was needed to find a resolution to the impasse between Greece and its creditors. The most likely candidate for such as role was the IMF.
Three days before the Greek referendum on whether or not to accept the Troika’s proposals, the IMF has stepped onto the stage. To the undoubted surprise of the other two partners in the Troika (the European Commission and the ECB), the IMF argues that Greece’s debts are unsustainable and that much more is needed than a mere bailout (which simply rolls over the debt).
According to the IMF, Greece needs €52bn of extra funds between October 2015 and December 2018, large-scale debt relief, a 20-year grace period before making any debt repayments and then 
debt repayments spread over the following 20 years. In return, Greece should commit to supply-side reforms to cut out waste, reduce bureaucracy, improve tax collection methods and generally improve the efficiency of the economic system.
It would also have to agree to the previously proposed primary budget surplus (i.e. the budget surplus excluding debt repayments) of 1 per cent of GDP this year, rising to 3.5 per cent in 2018.
So it this what commentators have been waiting for? What will be the reaction of the Greeks and the other two partners in the Troika? We shall see.
Articles
IMF says Greece needs extra €50bn in funds and debt relief The Guardian. Phillip Inman, Larry Elliott and Alberto Nardelli (2/7/15)
IMF: 3rd Greek bailout would cost €52bn. Or more? Financial Times, Peter Spiegel (2/7/15)
IMF: Greece needs to reform for sustainable debt, financing needs rising CNBC, Everett Rosenfeld (2/7/15)
The IMF has made an obvious point about Greece’s huge debt. Here’s why it still matters Quartz, Jason Karaian (3/7/15)
Greece: when is it time to forgive debt? The Conversation, Jagjit Chadha (2/7/15)
IMF Analysis
Greece: Preliminary Draft Debt Sustainability Analysis IMF (2/7/15)
Preliminary Debt Sustainability Analysis for Greece IMF (25/6/15)
Questions
- To which organisations is Greece indebted? What form to the debts take?
- To what extent is Greece’s current debt burden the result of design faults of the euro?
- What are the proposals of the IMF? What effect will they have on the Greek economy if accepted?
- How would the IMF proposals affect aggregate demand (a) directly; (b) compared with the proposals previously on the table that Greece rejected on 26 June?
- What would be the effects of Greek exit from the euro (a) for Greece; (b) for other eurozone countries?
- What bargaining chips can Greece deploy in the negotiations?
- Explain what is meant by ‘moral hazard’. Where in possible outcomes to the negotiations may there be moral hazard?
- What has been the impact of Greek austerity measures on the distribution of income and wealth in Greece?
- What are the practicalities of pursuing supply-side policies in Greece without further dampening aggregate demand?
The negotiations between Greece and the ‘troika’ of creditors (the IMF, the European Commission and the ECB) have seen many twists and turns before breaking down on 26 June. Throughout, both sides have sought to give as little as possible while seeking a compromise. Both sides have claimed that their position is reasonable, even though a gulf has remained between them.
What has been playing out is a high-stakes game, where the optimum outcome for each side is quite different.
Greece seeks bailout terms that would allow it to achieve a smaller primary budget surplus (but still a surplus in the midst of a deep recession). The surplus would be achieved largely through tax rises on the wealthy rather than further cuts that would hit the poor hard. It is also seeking a substantial amount of debt forgiveness to make servicing the remaining debt possible.
The troika is seeking a larger budget surplus than the Greeks are willing to contemplate. This, it maintains, should be achieved largely through additional cuts in government expenditure, including further reductions in pensions and in public-sector wages.
Both sides used threats and promises as the negotiations became more and more acrimonious.
The troika threatened to withhold the final €7.2bn of the bailout necessary to pay the €1.6bn due to the IMF on 30 June, unless the Greeks accepted the terms of the austerity package put to them. The Greek Prime Minister, Alexis Tsipras, in rejecting the proposals, called a referendum on the package. This threatens the stability of the eurozone as a No vote, if it led to a Greek exit from the eurozone, could undermine confidence in monetary union. After all, if Greece could be forced out, other countries facing severe difficulties might also be forced out at some point in the future. Once a country leaves the eurozone, the monetary union becomes more like a system of pegged exchange rates. And pegged exchange rates are open to destabilising speculation at times of economic divergence.
A Greek exit from the euro (dubbed ‘Grexit’) is seen as undesirable by most Greeks and by most politicians in the rest of Europe. The optimum for both sides collectively would be a compromise, which saw more modest cuts by Greece and the eurozone remaining intact. By both sides seeking to maximise their own position, the Nash equilibrium is certainly not the best outcome.
But as long as the troika believes that the Greeks are likely to vote Yes to the proposed bailout terms, it still hopes to get the outcome that is best from its point of view – an outcome that would probably involve regime change. And as long as the Greek government hopes that a No vote will force the troika to think again and come back with less austere proposals, it still hopes to get the outcome that is best from its point of view. But the outcome of this game of ‘chicken’ could well be Grexit and a Nash equilibrium that neither side wants.
But while the endgame is being played out by politicians, people in Greece are suffering. Policies of severely depressing aggregate demand to turn a large budget deficit into a primary budget surplus have led to the economy shrinking by 26%, overall unemployment of 27% and youth unemployment of over 60%. The Greeks truly believe themselves to be stuck between a rock and a hard place.
The following articles look at the nature of the ‘game’ being played and at the effects on the Greek economy, both of the proposed austerity package proposed by the troika and Grexit. They also look at the knock-on effects for the eurozone, the EU and the global economy.
Can game theory explain the Greek debt crisis? BBC News Magazine, Marcus Miller (26/6/15)
Against the Grain: What Yanis Varoufakis can learn from a real game theory master – Nicola Sturgeon City A.M., Paul Ormerod (24/6/15)
John Nash’s Game Theory and Greece Bloomberg, Mohamed A. El-Erian (29/5/15)
The Greek crisis: that 1931 moment The Economist, Buttonwood column (23/6/15)
How game theory explains Grexit and may also predict Greek poll outcome The Conversation, Partha Gangopadhyay (1/7/15)
Greece debt crisis: Tsipras may resign if Greeks vote yes BBC News (30/6/15)
Greek debt crisis: Is Grexit inevitable? BBC News. Paul Kirby (29/6/15)
Existential threat to euro from Greek exit BBC News, Robert Peston (29/6/15)
How I would vote in the Greek referendum The Guardian, Joseph Stiglitz (29/6/15)
Greece in chaos: will Syriza’s last desperate gamble pay off? The Guardian, Paul Mason (29/6/15)
What happens if Greece defaults on its International Monetary Fund loans? The Telegraph, Mehreen Khan (30/6/15)
For Greece’s international creditors, regime change is the ultimate goal The Telegraph, Jeremy Warner (29/6/15)
Europe has suffered a reputational catastrophe in Greece The Telegraph, Ambrose Evans-Pritchard (2/7/15)
Questions
- What is meant by a primary budget surplus?
- What was the troika’s proposal on the table on the 26 June that was rejected by the Greek government?
- What was the Greek government’s proposal that was rejected by the troika?
- Explain the decision trees outlined in the first BBC article below.
- In terms of game theory, what form of game is being played?
- Are the negotiations between the Greek government and the troika a prisoners’ dilemma game? Explain why or why not.
- Does the game being played between the SNP and the Conservative government in the UK offer any useful lessons to both sides in the negotiations over Greece’s possible bailout and its terms?
- Does a No vote in the referendum on 5 July imply that Greece must leave the euro? Explain.
- What would be the effects of further austerity measures on aggregate demand? What benefits to the Greek economy could be achieved from such measures?
- Why may pegged exchange rates be regarded as the worst of both worlds – a single currency in a monetary union and floating exchange rates?
The UK’s balance on trade continues to be sharply in deficit. At the same time, both manufacturing and overall production are still well below their pre-crisis levels. What is more, with a sterling exchange rate that has appreciated substantially over recent months, UK exports are at an increasing price disadvantage. The hoped-for re-balancing of the economy from debt-financed consumption to investment and exports has not occurred. Investment in the UK remains low relative to that in other major economies (see).
Finally with a higher exchange rate, the UK’s terms of trade have been improving. The downside is that it makes UK exports more expensive in foreign currency terms, but it also makes commodity prices cheaper, which have already fallen in dollar terms, and also the prices of imported component parts. This helps offset the effect of the appreciation of the exchange rate on exports.
