Rebalancing needed in order to sustain the recovery
As late as 18 months ago, people who talked about recovery were regarded as optimistic at best and seriously deluded at worst. But, after 5 positive quarters, and with a forecasting consensus of solid, energised growth for the next year or so, recovery is a fact and there is growing impatience for it to translate into higher living standards.
The economic debate has shifted accordingly from macroeconomic disputes around the relative importance of monetary and fiscal policy in supporting domestic demand in a depressed economy to the question of how the recovery in output can be sustained. And this, in turn, has raised 2, partly overlapping, questions.
One is about how to restore labour productivity trends which have stagnated since 2008. Without productivity growth we will not escape the low-wage, low-productivity trap.
The other is about how to ensure that growth is driven more than it has been - particularly in the pre-crisis decade – by business investment and by exports (and import-competing goods and services) and less than it has been by private and government consumption, especially if the latter is financed by unsustainable levels of private and government borrowing and debt.
These issues overlap to the extent that productivity growth depends on capital investment and on the growth of manufacturing, which in turn drives the export of goods.
Productivity remains weak, but is key to rebalancing
The productivity issue has polarized debate. Some regard the currently depressed productivity levels as a temporary, cyclical phenomenon while others believe there is a deeper structural problem.
I incline to the latter view. Ian McCafferty, for example, has attributed 60% of the decline in productivity from its pre-recession peak to fundamental changes in several specific sectors: oil and gas, where it is proving more difficult and costly to extract resources from new fields; banking, where high productivity investment banking has severely contracted as regulation has intervened; and aviation where tighter security has reduced productivity.
Those high productivity sectors which we need to expand, like advanced manufacturing, are constrained by a damaged banking system which is providing limited credit to small and medium sized enterprises – as well as by skills shortages and a lack of investment. The implication is that, beyond the current recovery, it will be difficult to sustain rapid growth in output and living standards without a major spurt of productivity.
There is a further link here to the wider question of rebalancing. In the first stage of recovery, it mattered little that growth was driven by consumption. But sustained, rebalanced recovery will only happen if growth is driven to a greater extent by private investment, and by the externally traded sectors of the economy – exports in particular.
Investment is beginning to recover
On the first of these factors, there is some encouragement from recent figures suggesting that business investment has been growing strongly, with growth of more than 8% forecast for 2014 and 2015. But investment levels are still well below where they once were. As a share of GDP, business investment has fallen over the last 15 years (-3% in real terms); fixed investment is at its lowest since the mid-1980s (1986), while – for more than 2 decades – the UK has consistently been at or near the bottom of the OECD range for fixed investment. The current upturn in business confidence and investment have improved the medium term outlook, but to change the structural picture, the barriers to greater business investment need to be overcome. For example, we still have more to do here to promote long-term, investment-oriented decision-making in corporate boardrooms.
But exports remain weak and the current account deficit is of concern
There is, though, little sign yet of recovery in exports which fell in 2 of the last 4 quarters and grew by only 0.5% in 2012 and 2.1% in 2013, despite the competitive benefits of a 25% depreciation in Sterling (on an effective exchange rate measure) in the wake of the financial crisis. Around half of exports go to the EU, where demand has been contracting. And although a great deal of marketing effort is bearing fruit in double digit annual growth in some important and rapidly growing emerging markets, this is often from a low base and there are serious, short-term supply constraints: inadequate supporting sales infrastructure, which requires long- term investment in local networks; export credit availability; supply chains weakened in the financial crisis and during the preceding years. Moreover, incomes in emerging market economies are, in most cases, yet to reach the levels necessary to demand the UK’s world-class services offering.
We must be realistic about the scale of the challenge – in 2013 our trade in goods deficit stood at 6.7% of GDP (deficit including services was 1.8%) and so far in 2014 we have imported £44.5 billion more in goods than we have exported. Moreover, the deficit on the current account of the balance of payments, at 4.4% of GDP in the first quarter of 2014, remains high by historical standards and a concern. The cause of the recent deterioration is the fall in investment income from overseas assets – until 2012, deficits on trade in goods and services were offset to some extent by repatriated income from UK investment overseas.
The economic orthodoxy of recent decades has been that a current account deficit of the balance of payments does not matter, so long as the prospects for financing it are sustainable. Traditionally a current account deficit used to worry governments since, under fixed exchange rates, a prolonged and large deficit could presage a devaluation and a ‘run on the currency’.
We now recognise that exchange rate movements owe more to expected interest rate differentials as determinants of capital flows, since capital movements are far more substantial, and volatile, than trade flows. This is why, despite the weakness of the trade and current account balance, there can be an appreciating currency, as has happened in early 2014 (a 4% effective rate appreciation since January 2014). Similarly in the period from 1998 to 2008 there was a weak trade and current account balance and a very strong currency, which in turn did severe harm to export competitiveness.
This year’s appreciation of Sterling might prove to be a short term issue. But business is concerned and I believe we should not simply ignore what is happening in the balance of payments. We need to understand it. The deficit may not be a problem in itself but it could be a symptom of a larger one, reflecting the damage during by a long period, before the crisis, of growth driven by domestic credit expansion and non-traded activities like property. This is not a good platform for export-led recovery and the challenge for more balanced growth.
The role of the exchange rate
How much should we worry about Sterling’s appreciation? Recent experience suggests that the connection between exchange rates and exports may have begun to slip – there has been a weaker connection between Sterling’s crisis-driven depreciation and the strength of UK exports than we might have expected and hoped for. One potential explanation of the UK’s exports becoming less price sensitive could be the growing dominance of services in our export mix.
And of course the picture is different for different sectors of the economy. Some are far more price sensitive than others, and many export goods are reliant on imports of components. This is a point worth underscoring – recent work by the OECD and WTO shows that the UK is linked in to regional and global supply chains. Our export success depends on imported intermediary goods for our own exports, and our exports provide intermediary goods for others’ exports.
So the extent to which further rises in Sterling will hit our export potential is unclear, but we are aware of the concerns of industry.
Improving productivity can soften the exchange rate challenge
It’s important to remember that business can respond, and this is yet another part of the debate around productivity.
Boosting productivity, notably in the manufacturing sector, can reduce unit labour costs and therefore help to keep prices lower in the face of a rising exchange rate. Indeed there are signs that manufacturers are succeeding in doing this, with output per hour worked up by 1.4 and 1.5% in the last 2 quarters respectively. This, in part, reflects the broader capacity for productivity to recover in the UK, which remains 16% below its pre-crisis trend.
And there’s an important link to the investment outlook I mentioned earlier. A significant proportion of the UK’s productivity lag with the US (a third or more) and particularly Germany and France (more than 2 thirds), is down to lower investment in fixed capital, and therefore lower capital available per worker. So a brighter fixed investment outlook, coupled with businesses focused on making productivity gains, can provide some buffer against the exchange rate outlook.
But clearly there is a limit to business’ ability to absorb a stronger pound. And I recognise that while changes to exchange rates happen immediately, driving change in productivity is a long-term project. A particular concern to businesses seeking to grow their exports is the unpredictability of the outlook in the short term, as well as the broad direction of appreciation.
The policy response
This raises the question of the policy response, and in particular how we should view changes in the exchange rate. The role of the exchange rate is important for macroeconomic policy. In the boom period before 2008 a strong currency contributed to meeting the MPC’s inflation objective while the post 2008 depreciation complicated it. Exchange rates are impacted in turn by movements in interest rates and currency appreciation reflects expectations that interest rates will begin to rise soon. Forward guidance has an important role in managing expectations and can potentially lead to less sudden appreciation as there are fewer surprises. A strengthening exchange rate, whilst still significantly below the peaks of 2007, keeps a downward pressure on imported inflation.
Unfortunately, an uncompetitive exchange rate also frustrates the objective of removing imbalances in the real economy. We cannot risk repeating the damaging experience of the so-called boom period before 2008. This means challenging the rather flippant economists’ mantra that the exchange rate is nothing more than the price which reflects the supply and demand for foreign exchange. True but trivial. The exchange rate does matter for the real economy.
In practice, a sustained improvement in the external position has to be based on consistent, long-term policies which support exporters and import-competing activities. A centrepiece of these policies is the Industrial Strategy. This has established a long-term partnership arrangement in the main sectors for traded goods (cars, aerospace, pharmaceuticals) and services (creative industries, professional services, education) and seeks to address major areas of market failure which are inhibiting performance – especially access to finance, which is being tackled through the Business Bank.
In relation to exports, what specifically can be done to boost them? A lot depends on external conditions. The evidence suggests that the relationship between UK exports and the external demand environment is stronger than that between the exchange rate and our export prospects. Whereas a fall in exchange rates of 10% might see our export share increase by 4%, an improvement in export market demand of 10% might generate an equivalent 10% increase in exports. But this does not in itself equate to a boost to GDP growth from net trade, as imports are expected to roughly keep pace with export growth, according to the Office for Budget Responsibility.
We can’t control the external demand environment – the prospects of the Eurozone, of the US, and of the rest of the world. But we can work with partner countries, for example at the G20, to deliver an open, growing and rebalanced global economy.
What we can affect is the environment in which growing, exporting businesses operate in the UK and the support they can get from government and its agencies. UKTI has helped over 40,000 businesses to export and helped UK companies win £22.6 billion of new business. And this support is available for every kind and size of business. Since April 2014, for example, every MSB in the country has been offered tailored trade advice and an intensive programme of support to help them start exporting or to break into new markets.
In September 2013 we launched a Direct Lending Facility, which means that £3 billion is now available to lend to overseas buyers to purchase UK exports. In December (2013) we doubled UK Export Finance’s capacity to support UK exports to £50 billion. And we will broaden UKEF’s statutory powers to support exports through the Small Business, Enterprise and Employment Bill.
UKEF is the former ECGD and until recently was largely concerned with underwriting big long-term contracts – for arms exporters, in particular. In 2011, I introduced a suite of new short-term export credit products targeted at smaller and medium sized companies. We initially had difficulty raising awareness of these products but they are now better understood and better used, thanks to close collaboration between UKTI and UKEF.
So the offer to business eager to export is a strong one. And there are encouraging signs that entering new markets is firmly on the British business agenda. Introducing new products or expanding into new markets was the top corporate priority in the next 12 months, according to Deloitte’s quarterly CFO survey. Converting this ambition into the reality of a rebalanced outlook captures the policy challenge facing us.
To conclude, the trend in the external deficit, its magnitude, and the persistence of our trade imbalance mean that we must devote sustained attention to external competitiveness if we are to rebalance the economy. The government is focused on doing everything it can, through UKTI directly and also through our Industrial Strategy, to support growing exporting businesses, which have the power to drive our recovery, tackle our trade deficit and underpin our nascent recovery.