Sunday, February 25, 2007
Trade see-saw could leave sterling exposed
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

In today's other Sunday papers, Liam Halligan in The Sunday Telegraph looks at the pressure on the government to settle the "pension theft" case following last week's High Court judgment, while William Keegan in The Observer is worried about Middle East instability and a US-led attack on Iran. Here's my piece:

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I don't often do reader requests, not least because some of them are not that polite. But let me break with tradition, in response to a mini-avalanche of demands.

The cause of the fuss was figures released a couple of weeks ago, showing Britain ran a trade deficit in goods last year of no less than £84.3 billion. Let me pause for effect while that number sinks in.

Why, I have been asked repeatedly, is this not the cause of more comment? What does it say about the state of Britain’s economy and competitiveness? How long can we go on like this?

That £84.3 billion is a lot of money. It means, for every man, woman and child in the UK, imports of goods exceed exports by more than £1,400. Not much of that was due to oil, which was in deficit last year but only by £3.7 billion.

Quite a lot of it, on the other hand, was due to our appetite for manufactured products made abroad. Until 1982, Britain had never had a trade deficit in manufacturing, such was our status as the workshop to the world. Last year, however, the deficit was a fraction under £60 billion.

Once our ports sent “made in Britain” products to the four corners of the globe; the UK was the most powerful trading nation in the world. Now, the ports are busier handling imports.

Britain exports more than it imports when it comes to services, where the UK’s comparative advantage now lies. But even with a healthy surplus in services, the overall trade deficit last year was nearly £56 billion, not far short of £1,000 a head. In 1997, it should be pointed out, the country had a trade surplus on this measure.

Disturbingly, there is no easy explanation for last year’s deterioration. If consumer spending had been roaring away we could explain the deficit as overexuberance sucking in imports.

But spending has been subdued, up only 2% last year, while the deficit in goods rose from “only” £69 billion in 2005 and the total deficit increased from £45 billion. The trade deficit, which is “structural” (barely affected by the economic cycle) seems destined to rise by £10 billion a year. Soon it could top £100 billion.

We used to say, faced with much more modest amounts of red ink in the old days, that as a nation we were living beyond our means. We are doing that in spades now, so how come this excites relatively little comment? In those days, the trade figures probably represented the single most important economic indicator.

One reason a huge trade gap excites less attention is because the statistics are clouded by distortions related to so-called missing trader Vat fraud. This “carousel” fraud occurs where goods are imported and reexported, perhaps several times, to defraud the tax authorities. But, while this has distorted the numbers, it has not distorted them that much. Whichever way you look at it, the trade deficit is enormous.

A second reason is that financial markets no longer move much in response to the trade figures. Compared with, say, inflation, pay, economic growth, retail sales or housing statistics, the trade numbers come well down the list of indicators, partly because neither the Bank of England nor the Treasury reacts to them by changing policy.

In the past, chancellors used to dread poor trade figures. James Callaghan, Labour chancellor in the 1960s, described sitting in the Treasury and enduring that sinking feeling when the trade gap led to a run on the pound and the leaching away of the country’s foreign-currency reserves.

Now, international trade flows are dwarfed by capital flows. Britain’s trade deficit is partly offset by a service-sector surplus and interest, profits and dividends from abroad, but it is mainly swamped by capital inflows. Long-term capital has been flooding into Britain, both for setting up new operations and foreign takeovers of UK businesses.

Last year Britain attracted nearly £90 billion of foreign direct investment according to the United Nations Conference on Trade and Development, easily the largest in Europe. There are also huge flows of portfolio investment — purchases of shares and government bonds — in and out of Britain each year.

This is why a gaping trade deficit has been associated not with a plunging pound but with a strong and stable exchange rate. Sterling has been a manly performer for more than a decade, enjoying a sustained run the likes of which has not been seen for many decades, even as the trade figures have got worse. Capital inflows have kept the pound strong, even as an outflow of cash to pay for all those imports should have been pushing it down.

Indeed, there is a neat symmetry here, although it is not one any exporter would welcome. The balance of payments has to balance. Inflows of capital mean it balances at a high level for sterling, the consequence of which is to make life harder for exporters and easier for importers.

Is this how life will be from now on? Instead of a nation paying its way by trade, does the UK make its way in the world by attracting foreign investment, even if that means selling off the “family silver”?

We are some way from that point. UK assets overseas are broadly equal to foreign-owned assets in Britain, although British investors tend to get a higher return from their overseas holdings than foreigners do here.

Even so, dependence on capital inflows in the face of a growing trade deficit leaves Britain, and sterling, vulnerable. In evidence to the Commons Treasury committee to mark the approaching 10th anniversary of independence, the Bank warned that the symmetry that has kept the pound strong despite the widening deficit may have to be reversed.

Sterling would have to fall so that exports become more competitive and start making more of a contribution to growth. This is the “great rebalancing” that the Bank has been looking for since the early days of independence.

One day it will happen. The tricky thing is guessing when.

PS: In Tokyo they have just doubled interest rates, with an 8-1 vote on the Bank of Japan’s policy committee and the deputy governor in a minority of one. Mind you, the doubling was only from 0.25% to 0.5%. Here, the Bank’s monetary policy committee (MPC) voted 7-2 this month to leave Bank rate at 5.25%. The MPC’s new boys, Tim Besley and Andrew Sentance, voted to hike.

There has been a lot of comment about the way MPC members are chosen and whether they have to be “friends of Gordon”, or at least “friends of Gordon’s friends”. The answer is that while some have connections to the chancellor’s circle, most have not.

For me there is a more important issue. Two of the current members of the MPC, the hawkish Besley and the dovish David Blanchflower, joined with no experience of analysing UK monetary policy, let alone conducting it.

It is in the nature of the committee that nobody joins with practical experience of making interest-rate decisions. We wouldn’t allow novices to carry out brain surgery, so why do we let them loose on the delicate task of conducting monetary policy?

The answer is that each new member should have a period, at least three months, of observing and shadowing the MPC, including sitting in on the meetings. That would require, of course, that the chancellor makes up his mind sooner about new appointments.

As for last week’s minutes, the tone was of a committee that still expects to have to raise Bank rate again but is in no particular hurry to do so. A survey by the Bank’s own agents suggests that the pickup in pay settlements in response to higher inflation will be modest. As always, watch the data.

From The Sunday Times, February 25 2007

Comments

Nice article David. The point that the balance of payments has to balance is fundamental, but I think it is not mentioned enough in the press. As with the US trade deficit, it is not the outright deficit itself that is the problem, but the willingness of investors to finance it. The greater the deficit, the greater the risk of an unwind, but on its own, a deficit on it's own doesn't have to be problematic.

I do believe the pound is overvalued and I tend to trade it from the short side, but the trade balance and monthly statistics don't figure in to my thinking. While capital inflows have the potential to be less robust than having a trade balance surplus, I think the risk of 'hot money' flight is negligible.

Posted by: Caravaggio at February 25, 2007 12:23 PM

To second Caravaggio. Given today's exchange rate environment, the trade balance is hardly the concern it was through most of the last century. So much so that the 'living beyond our means' arguments, which were abundant during the USD weakness of 2004, sound a little dated, its naive to evaluate an economy like a company - with the balance sheet approach.

Taking away the Foreign Direct Investment element, and i think that sterling will always be able to stand its ground in the markets, especially in the context of global diversification away from USD. Recall the UK's other competitive advantage - diversity - the world loves us, surely. + consider the strength of London as the financial intermediary of choice.

Finally, on the Bankof England's "rebalancing" aim - what a joke. Granted, i didn't believe them about falling oil prices, or the strength of an investment led recovery, but this one is ridiculous. UK exporters will never be able to compete on price, irrespective of wthat sterling does, the core of the problem is clearly in the regulatory and fiscal tapestry of gulag-Britain. Strategy: Buy sterling / sell Britain ?

Posted by: Jonathan Blaze at February 25, 2007 02:21 PM

To second Caravaggio. Given today's exchange rate environment, the trade balance is hardly the concern it was through most of the last century. So much so that the 'living beyond our means' arguments, which were abundant during the USD weakness of 2004, sound a little dated, its naive to evaluate an economy like a company - with the balance sheet approach.

Taking away the Foreign Direct Investment element, and i think that sterling will always be able to stand its ground in the markets, especially in the context of global diversification away from USD. Recall the UK's other competitive advantage - diversity - the world loves us, surely. + consider the strength of London as the financial intermediary of choice.

Finally, on the Bankof England's "rebalancing" aim - what a joke. Granted, i didn't believe them about falling oil prices, or the strength of an investment led recovery, but this one is ridiculous. UK exporters will never be able to compete on price, irrespective of wthat sterling does, the core of the problem is clearly in the regulatory and fiscal tapestry of gulag-Britain. Strategy: Buy sterling / sell Britain ?

Posted by: Jonathan Blaze at February 25, 2007 02:23 PM

Dear David,

A lot of funds finding its way into the sterling causing the pound to rise could be the " carry trade" where hedge funds borrow in Yen and convert to sterling because of higher interest rates and relative stabilty of the sterling pound.

How much of these funds will have to go back when Japanese interest rates rise is anybody's guess however the markets take it that it will take interest rates of around 2% to cause the yen to strengthen and for hedge funds to start moving back to Japanese yen.

Probably we will have to see when this happens however the last increment in Japanese interest failed to move the sterling one single bit.

Posted by: Hitesh Damani at February 27, 2007 09:37 AM
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