October 1, 2013 by johnmillsjml
Exchange Rate Reform Group
BULLETIN – October 2013
Import substitution is just as vital as export growth to the UK economy
Despite some recent signs of improvement, the UK economy is still doing incredibly badly. Our Gross Domestic Product (GDP) is still 3% lower in real terms than it was at the end of 2007 and – allowing for our rising population – GDP per head is 6% down on what it was in 2007. Why is our performance so poor?
The main reason is that the UK economy is hobbled by its weak balance of payments position. We have not had a surplus on our trade in goods since 1982 and we have not had an overall surplus in any year since 1983 – 30 years ago. As a result, we have been unable for a long time to run our economy at full throttle. It is the resulting chronic lack of adequate demand which explains why we have such high unemployment, low growth, rising inequality, overstrained public services, stagnant living standards and declining international significance and why government debt is mounting to unmanageable proportions. Unless we can make the UK economy competitive enough for us to be able to pay our way in the world, none of these problems will be soluble.
The only way to make the UK economy competitive in world markets is for us to have a substantially lower exchange rate than we have at the moment. If we want to get the economy growing again at 3% to 4% per annum and to get unemployment down to perhaps 3%, we will need an exchange rate which is about a third lower than it is at the moment – a little over £1.00 = $1.00 and around £1.00 = €0.80. If we had an exchange rate at this level, why would this make our economy perform so much better? How would this come about? In particular, what is the balance between the benefit which we could expect to achieve by a higher volume of exports compared to what we would save in foreign exchange by having a lower volume of imports?
The reason why a lower exchange rate is so important is that it both allows UK exporters to charge the rest of the world much lower prices while still making the same amount of money and at the same time imports of all kind become more expensive, switching demand to home production. The key issue then is to determine how sensitive both exports and imports are to price changes. A large amount of work has been done both by official and academic organisations on this subject, most recently summarised in a working paper (IMF reference WP/10/180, particularly Table 2 Page 21 and Table 1 page 15) published by the International Monetary Fund in 2010. This showed just how sensitive to pricing both UK imports and exports are. The elasticity of demand for UK exports over a two to three year period reported by the IMF is 1.37 and -1.68 for imports. What this means is that if the price charged by the UK for our exports goes down by 1%, the value of our exports can be expected to rise by 0.37%. Similarly, if the cost of our imports goes up by 1% the value of our imports can be expected to fall by 0.68%. It may be wise not to assume too much precision in these figures but, as they were drawn from a large sample, it is very unlikely that they are not generally in the right area. This being the case, the following important conclusions can be drawn:
1.A The condition which has to be met for a devaluation to produce a long term positive improvement in the balance of payments of a devaluing country (known as the Marshall Lerner Condition) is that the sum of the elasticities (ignoring the minus sign for imports) has to be more than 1. It is clear that in the UK’s case this condition is easily met. Indeed, the UK’s combined elasticities at 3.05 (1.37 + 1.68) are well above the average for industrialised countries which the IMF reports as being 2.25. This means that a significant devaluation would be certain very substantially to improve our foreign trade position.
1.B It may also be significant that the elasticity of demand for imports in the IMF report is shown to be higher than for exports, although other older studies have not shown this always to be the case. If the IMF figure is correct, however, it indicates that there is even more to be gained in improving the foreign payment balance from import substitution than there is from increased exports.
Improving the Foreign Payments Balance
There are thus two separate ways in which the UK balance of payments can be brought back into the black while at the same time the economy can be expanded and unemployment much reduced. One is increased exports and the other is import substitution. Taking these in turn:
2.A The key to making our export performance better is to make exporting more profitable while at the same time making our exports more competitive. The deeper the devaluation the easier it is to achieve both these objectives at once. This is because the effect of a much lower pound is to enable our exporters to charge out all domestically incurred costs to the rest of the world much more cheaply than before while still increasing profit margins. Although about 60% of all our exports are goods rather than services, indicating that the total scope for exporting services is less than for exporting goods, services have nearly all their costs incurred in their local currency. They are likely, therefore, to benefit even more than manufactured goods from a more competitive currency. This is because for manufacturers, typically about 20% of their costs are raw materials and other inputs and 10% depreciation of plant and machinery for all of which there are world prices, whereas almost 100% of the costs of service industries are domestically incurred. The fact that services comprise an increasingly large proportion of all our exports may explain why the available figures suggest that the price sensitivity of all our exports is increasing rather than falling.
2.B Perhaps even more important than increased exports resulting from a lower exchange rate would be a corresponding drop in imports. Higher prices for imports, especially as a result of a deep devaluation, would strongly encourage the production of goods within the UK which had previously been imported. The same would apply – perhaps even more strongly – to services. Holidays abroad for UK residents – which count as imports – would become considerably more expensive, thus encouraging people not to have holidays overseas – and this is a price which has to be paid for making the economy more competitive generally. Correspondingly, however, foreign tourism in the UK is likely to increase substantially. On the other side, however, another important factor is that there is a large amount of international evidence that it takes longer for exports to grow after a devaluation than for imports to fall. It will therefore take two to three years for the full benefit in terms of improving the foreign trade balance to come through.
It is sometimes claimed that the UK economy is now in such poor shape that it is incapable of responding to price and profitability signals of the kind described above. This is extremely unlikely to be true for all of the following reasons:
2.A Despite the fact that we still have a large visible trade deficit, UK exports have grown substantially since the 2007/2009 devaluation. Between 2009 and 2012 UK exports of goods rose 31% by value and 17% by volume. This certainly shows that expansion of sales abroad is possible. Unfortunately, imports of goods also rose over the same period by 31% and 15% by volume but from a higher base, so the visible deficit grew larger rather than becoming smaller.
2.B At £1.00 equals a little over $1.00, however, the picture would change dramatically. The problem is that at £1.00 equals $1.50 to $1.60, import substitution on any sufficient scale is not worthwhile. With the exchange rate a third lower than it is now, however much, in particular, of the light manufacturing which relocated along the Pacific Rim as we de-industrialised would become more economical to locate again within the UK than thousands of miles away on the other side of the world. Most light industrial production – such as injection moulding, metal pressing, fabrication and assembly – involves processes which are relatively easy to establish, and machinery, equipment and raw materials which are readily available on world markets. This is why re-establishing the UK as sufficient of a manufacturing base to enable the economy to grow at 3% to 4% per annum and unemployment to start to fall to perhaps 3% would take no more than two to three years.
2.C The path back to prosperity for the UK therefore lies both in increased exports and import substitution, covering both goods and services. In 2012 – treating the figures for this year as a starting point – our foreign payments deficit was £59bn – about 4% of our GDP. £34bn of this sum was our trade deficit (a deficit on goods of £108bn as against a surplus on services of £74bn) and the remaining £25bn deficit was made up of net payments to the European Union (£12bn), net remittances overseas (£6bn), net income paid abroad (£2bn), with most of the balance being government aid programmes. If the economy is expanded strongly, imports are bound to rise. This is why a very substantial increase in exports and a strong move towards import substitution will be needed – all made possible by a big devaluation – to cater for the needs engendered by much more rapid growth.
Is all this possible? Emphatically, it is. None of the standard objections to devaluing to achieve a competitive exchange rate stand up to close scrutiny. It is not true that devaluation generally increases inflation above what would have occurred anyway as can easily be seen by looking at all the readily available statistical evidence. It is not true that a lower exchange rate makes everyone poorer. Again, the evidence is strongly to the contrary and if the economy grows faster as a matter of logic GDP per head must go up and not down although there will inevitably be some losers. It is not true that the exchange rate is fixed by market forces and the government cannot get it changed. There are numerous examples showing the opposite, not least Japan which has devalued the yen by about one third in the last year. Nor is retaliation likely to be a threat, because our share of world trade is now so small – at well under 3% – that what we do does not nowadays make much difference to the rest of the world – as we saw when the pound fell from $2.00 to less than $1.50 between 2007 and 2009.
The reason we stick to a grossly over-valued pound has nothing to do with the impossibility of changing its external value and everything to do with the fact that our politicians, civil servants, commentators and academia are wedded to views on economics which are wholly out of kilter with what really needs to be done. Targeting inflation at 2% is not by a very long chalk the primary economic objective. Making sure that the exchange rate is at a competitive level is far, far more important. Until opinion changes to realising that this is the case, we will be condemned to little or no economic growth, stagnant living standards, overstrained public resources, an unfundable Welfare State, a pensions crisis, rising inequality both regionally and between socio-economic groups, mounting unemployment and declining international significance. Of course, a competitive pound is not a solution on its own. Many supply side policies will be needed to complement what needs to be done by making the UK economy more competitive internationally. The crucial point about the exchange rate, however, is that without getting this at the right level, no other mix of policies has got the slightest chance of working. This is the crucial perception which our policy makers need to take on board.
Published by the Exchange Rate Reform Group
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