Sunday, February 22, 2009
Relax a little: sterling's slump has a silver lining
Posted by David Smith at 04:00 PM
Category: Independently-submitted research

A guest piece in my Sunday Times slot by Ben Broadbent and Kevin Daly of Goldman Sachs.

This month the Pontin’s holiday company announced that, in response to a 20% increase in summer bookings, it is embarking on a £50m expansion of its British facilities. Meanwhile, Butlins - Pontin’s biggest rival - is opening a 200-room “boutique hotel” at its Bognor Regis complex as it expands into the middle market.

Many people saw this as a sign of hard times - families that would normally have travelled abroad are looking to save money on their holidays. There may be some truth in this. However, this is not just a story about people trading down in response to the recession - many high-end holiday cottages in Cornwall are also reported to be fully booked for the summer. The evidence remains largely anecdotal for now, but it appears that British tourism may be heading for a strong summer.

We think this is the start of a wider trend, driven by the weakness of sterling, whose benefits are likely to be witnessed first in sectors such as tourism but which will ultimately boost the whole of the British economy.

It is hard to overstate how big the collapse in sterling has been. On a trade-weighted basis, the exchange rate is down more than a quarter from the peak in mid-2007, at the start of the credit crisis - more than twice as big as the drop after sterling’s forced exit from the European exchange-rate mechanism in 1992, and close to the biggest-ever depreciation in 1931, when Britain abandoned the gold standard.

Why has this happened? It is tempting to attribute the fall to the perilous state of Britain’s economy - after all, our housing boom was one of the biggest in Europe and our spending imbalance one of the worst. The International Monetary Fund (IMF), for one, is forecasting that Britain will suffer the deepest recession of any big industrialised economy.

Appealing as this explanation may be, however, it is not consistent with the latest evidence of the economies’ relative strengths. UK businesses are pessimistic but, compared with their counterparts in the eurozone or America, they are somewhat less gloomy. Official statistics tell a similar story - eurozone GDP fell 1.5% in the fourth quarter of last year, the same as in Britain. Indeed, the global downturn has been remarkable not just for its severity but for its synchronicity.

We think a more plausible explanation for sterling’s weakness is the relationship between Britain’s net overseas investment and variations in global financial markets. Britain’s overseas assets are skewed towards equities (and other equity-style investments) while overseas investors are net holders of UK debt. Therefore, when global equities perform badly relative to bonds - as they do when investors become more risk-averse - the value of Britain’s net overseas assets tends to decline. This, in turn, induces a corrective fall in the currency.

Whatever the cause, sterling’s fall is a big stimulus for the economy. One way of measuring its significance is to translate it into equivalent changes in interest rates. There used to be a rule of thumb that a 1% fall in the exchange rate has the same effect on output as a 0.25 percentage-point cut in interest rates. Our own estimates suggest the effect is somewhat smaller than this - about 0.17 points. But even on this basis, the 27% decline in sterling since the start of the credit crunch is equivalent to an additional cut in interest rates of between 4 and 5 percentage points.

The easing implied by the decline in sterling, together with the drop in interest rates, is phenomenal. The chart above shows monetary conditions indexes for Britain and the eurozone (these combine short and long-term interest rates, together with the trade-weighted exchange rate, into a single indicator, with weights that reflect the importance of each input in driving year-ahead growth). Since the start of the credit crunch, UK monetary conditions have eased by more than 6 percentage points on the back of sterling’s decline.

These effects take some time to come through. They are also being dominated, for the moment, by the huge hit to global trade wrought by the credit crunch. Everyone’s exports are shrinking.

However, as the expansions announced by Pontin’s and Butlins indicate, the boost from sterling’s weakness can just as effectively come from import substitution as higher exports. Moreover, global downturns, even this one, have ends. While it would be premature to look for a significant impact from sterling’s fall any time soon, history suggests that this effect will eventually come through.

In 1991 and 1992, despite a continental boom induced by the reunification of Germany, British exports barely grew. Between 1993 and 1997, following a depreciation that was less than half as big as this one, they rose by almost 10% a year. And in 1931, the last time we saw a fall in the exchange rate of this magnitude, sterling’s decline contributed to economic expansion in Britain at a time when much of the rest of the world was still suffering in the middle of the Great Depression.

Britain is well placed relative to the eurozone in this regard. Eurozone monetary conditions have tightened by about 1.5 percentage points since the start of the credit crunch owing, in part, to a stronger euro. Even in normal times, a tightening of this order would slow growth significantly over a year. To face such a tightening in the middle of the worst financial crisis since the war is precisely what the eurozone does not need. We disagree with the IMF’s view that Britain will fare worst among industrialised economies.

Sterling’s collapse is no panacea. The benefits of a weaker currency are unevenly distributed and it clearly makes life a lot tougher for those who buy imports, including those who like to take their holidays abroad. But, while there will inevitably be rainy days for those holidaying in Britain this summer, economic prospects should gradually brighten as the year progresses.

PS: What role, you might ask, has budgetary policy to play in supporting British growth? Much political heat has been expended over the government’s decision to ease fiscal policy this year through a temporary cut in Vat. The opposition criticised the move as “irresponsible”, the German government called it “crass Keynesianism”, while France’s Nicolas Sarkozy has said that the Vat cut has “clearly not worked”.

So how does this “irresponsible and crassly Keynesian” fiscal stimulus compare with other budgetary packages? At about 1% of GDP in 2009, it is smaller than in France and Germany (both 1.5% of GDP), smaller than in the UK in 1992, when the Conservative government eased policy by 2% of GDP, and smaller still than in America (close to 4%). Moreover, the government intends to withdraw the stimulus in 2010, while other countries plan additional easing.

So the real problem is not that it involves Vat - retail spending rose strongly in December - but, thanks to a poor starting position for the public finances, the government can afford only a small easing in fiscal policy. Compared with the 6% boost implied by the sharp easing in UK monetary conditions, fiscal policy in the UK is likely to play a minor role in supporting growth.

From The Sunday Times, February 22 2009