UK trade improvement: hold your horses!
Nadya Mihaylova - 05 April 2017
Whoa there! Don’t jump to conclusions about the sharp narrowing of the UK trade gap, announced last Friday. Once trade in oil and erratics has been stripped out, there has been no underlying improvement – indeed the bilateral deficit with the EU has widened. This is exactly what the standard J-curve analysis would predict in the light of the material depreciation of Sterling last year. Thus far, Sterling export prices appear to be tracking import prices, suggesting that all the currency change has been absorbed in Sterling profit margins. There is still scope for a fundamental improvement in the trade balance, particularly with the EU27, but this remains a fond hope, not a reality. Hold your horses!
The quarter 4 2016 trade deficit narrowed to £4.8bn compared to £14.8bn in the previous quarter as a result of a substantial boost in exports of goods and services equivalent to £7.6bn and £2.4bn respectively. An increase of £2.5bn was attributed to highly volatile erratic commodities (such as non-monetary gold, silver, ships, and aircraft), with an additional £1.6bn to oil exports and £1bn to machinery. When oil and erratic items are excluded, however, we observe a slight deterioration: import growth of goods has exceeded that of exports, contributing to a small widening in the trade deficit (fig 1). There is still hope that the weak pound’s boost to competitiveness will become more broadly felt in various other sectors in the coming months. Optimism among UK manufacturers is running high due to the better outlook in demand from trading partners – a factor which is far more important than the change in the value of the currency. The UK manufacturing sector has shown resilient growth: the PMI moved to 54.2 points in March 2017, comfortably above the 50-point mark - albeit a little lower than market expectations.
The J-curve effect suggests that when a currency depreciates, a country experiences an initial deterioration in the trade balance as imports become more expensive and export prices remains close to unchanged as time is taken to negotiate the terms of new contracts. In the long-run, however, export volumes increase as foreign consumers respond to the lower prices and domestic consumers switch towards cheaper domestic products. Parts of this positive adjustment have already taken place in the UK economy as the gap between import and export volumes has been narrowed substantially in the past few quarters. However, it is important to notice that UK import and export prices are highly correlated reflecting the integrated supply chain where more expensive imported inputs have also translated into higher domestic inflation and export prices (fig 2). Equally, UK export firms may simply be reluctant to pass on the full benefit of the exchange rate change in an attempt to retain higher profits. Going forward, this could imply a more modest improvement in the trade balance than some expect.
According to the ONS, the narrowing in the current account deficit with EU countries is predominantly driven by an increase in the primary income as the earnings on foreign investments have increased. However, net trade in goods and services with the EU has not improved despite the weaker sterling (fig 3). The current account position with non-EU countries has also improved significantly since the currency depreciation – albeit this is mainly driven by higher exports of erratic items and a narrowing of the primary income deficit. Nevertheless, this positive growth may be sustained post-Brexit and it is less affected by the uncertainty over single market access.
Data Source: ONS
Data Source: ONS
Data Source: ONS
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