Abstract
This Selected Issues paper analyzes the specialty about the cyclical expansion in the United Kingdom. The paper reviews the labor market data, wage inequality, and implications for inequality. The study examines the contributions of information and communications technologies investment to output and labor productivity growth in the United Kingdom. The paper provides a qualitative assessment of the impact of the appreciation of sterling on U.K. foreign trade, and its effects on competitiveness, and the sectoral composition of production.
III. The Strong Sterling and the United Kingdom’s External Competitiveness1
1. Sterling has appreciated by almost 60 percent in real effective terms from the fourth quarter of 1995 to the fourth quarter of 2000, with two thirds of this appreciation taking place in the first two years (Figure 1).2 Considering that the U.K. is a very open economy (total trade accounts for over 50 percent of GDP, more than double when compared to the US and euro area), it stands to reason that such a drastic and fast appreciation must have had a sizable impact on the economy, in particular in the manufacturing sector. This paper tries to form a qualitative assessment of the impact of the appreciation of sterling on U.K. foreign trade, and its effects on competitiveness and the sectoral composition of production.
United Kingdom: Exchange Rates
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
Source: IMF, International Financial Statistics.2. This appreciation seems to be a significant factor behind the rapid deterioration in the external sector, although fluctuations in external demands particularly stemming from disparities in cyclical positions with respect to the euro area may have also played a role. The trade deficit has doubled since 1997 and the current account has shifted from a surplus of 0.8 percent of GDP in 1997 to an estimated deficit of 1.3 percent of GDP in 2000, despite the United Kingdom’s self-sufficiency in oil products. Non oil export volumes growth declined sharply after 1996 and did not start to recover until mid–1999 (Figure 2),3 losing some market share in world as well as euro-area exports (Figure 3). Imports grew strongly during this period, and import penetration (measured as imports as a ratio to GDP) has achieved record levels. As a result, the external sector has made a significantly negative contribution to GDP growth since 1996.
United Kingdom: Not Oil Exports. 12-inonth Rate of Growth, 4-Qiiartcr Moving Average
(in percent)
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
United Kingdom: Market share of Manufacturing Exports
(in percent)
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
Source: OECDUnited Kingdom: Export Market Sentiment
(percentage balance of negative and positive responses)
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
Source: CBI3. As the relative profitability of tradable goods declined, the trend shift in the structure of output towards services and nontradables become more pronounced in the late 1990s. Manufacturing output grew by an accumulated 2.2 percent over 1995–1999, while overall GDP grew by over 11 percent and the services sector grew by over 17 percent over the same period—a sharper shift towards services than experienced in France and Germany, for instance4 (Figure 5). By comparison, during 1985–1990, a period with no sizable misalignment of the exchange rate, accumulated growth in the manufacturing sector was 18 percent, compared to 16 percent for overall GDP and 17 percent for the services sector. This sectoral rebalancing was probably reinforced by the boom in equity markets, given the prominence of financial services in the U.K. economy. Indeed, the trade balance in the service sector improved despite the appreciation of the exchange rate (Figure 6). Some commentators (e.g. Goldman Sachs (2000)) have suggested that this boom in equity markets, by increasing the relative price of nontraded goods, explains the appreciation of sterling, similar to a Dutch disease phenomenon. On a related point, to the extent that traded services are more important in the U.K.’s economy than in the economy of its trading partners, the real appreciation measured on the basis of manufacturing unit labor costs (as in Figure 1) is likely to be overstated.
United Kingdom: Sectoral Analysis of Output
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
Source: ONS.United Kingdom: Evolution of Trade Balances
(in millions of pounds)
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
4. The question that arises is how U.K. Arms have reacted to the strong exchange rate5. Several aspects are important, including the pricing behavior of firms, the evolution of costs, the impact of the appreciation on investment expectations and the sectoral evolution of exports. These issues are discussed in turn.
5. U.K. firms appear to have reacted to the strong exchange rate appreciation with a pricing-to-market strategy6. This implies that firms lowered export prices in domestic currency and therefore squeezed margins in order to protect market shares. Margins could be squeezed partly because manufacturing exporting firms had accumulated substantial profits after the post-ERM devaluation. Rates of return averaged about 10 percent over 1993–1997 (compared with about 6 percent over 1989–93)7, which allowed firms to squeeze profits afterwards (Figure 7).8 Indeed, export prices in sterling declined sharply following the appreciation of the sterling; this decline took place across all sectors and was more acute for exports to the euro area, because of the weakness of the euro (Figure 8).
United Kingdom: Profitability Indicators
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
Source: ONS.1/ Defined as the ratio of operating surpluses compared to capital employed, in percent.2/Defined as a the ratio of an index of the unit value of exports of UK manufactures to an export weigthed index of UK producer prices of home sales of manufactures.United Kingdom: Export Prices
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
Source: ONS6. An important factor to consider was the behavior of costs. Unit labor costs in manufacturing grew at a brisk pace since 1995 owing to very low labor productivity growth. This led to stark competitiveness losses that compounded the negative effect of the appreciation of the nominal exchange rate. For instance, normalized unit labor costs in U.K. manufacturing grew by some 18 percent between the fourth quarter of 1995 and the fourth quarter of 2000, while they declined in France and Germany. 9 Firms reacted only in late 1998, when a sudden increase in labor productivity permitted some containment of costs (Figure 9).
United Kingdom: ULC in Manufacturing and its Components
(12-month rate of growth, in percent)
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
7. An additional response to the real appreciation was the shifting of the supply chain sourcing overseas, seeking lower cost suppliers. According to the CBI, this has been especially marked in automotive, electronics, and textile sectors (see CBI ( 2000)). Although optimal from an individual firm’s point of view, the side effect of this phenomenon is the threat that it poses to firms further down the supply chain in those sectors, especially in terms of investment plans and long-term profitability. Moreover, this may also inhibit the long-run investment plans of the firms outsourcing the production of intermediate goods, as they may eventually decide to relocate closer to their suppliers
8. In this vein, it appears that the evolution of the exchange rate seems to have been in the past an important determinant of investment sentiment. CBI survey data on investment expectations shows a negative correlation with the evolution of the real exchange rate (the correlation coefficient over the period is about–0.6). 12-month ahead investment expectations in manufacturing declined sharply in 1997, shortly after the appreciation of sterling began, and have not recovered significantly since (Figure 10).
United Kingdom: Investment Expectations
(next 12 months)
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
9. One question remains, however, namely whether the aggregate figures mask reallocation of resources at the sectoral level. In order to analyze this issue, Figure 11 shows, for various SITC sectors, the cumulative growth differential of exports in each sector with respect to total exports. If there have been no major sectoral shocks, other things equal, the growth differentials across sectors should not be persistent, as the different sectors deal with the appreciated exchange rate with a similar success on average. If, however, exchange rate fluctuations have a differential impact across sectors, growth rates will display divergence over time, although other factors—such as differential demand growth and secular sectoral shifts—could also play a role. In fact, the results show that there are essentially three groups of sectors. First, those that have thrived despite the exchange rate, growing consistently above the average. This group includes electrical machinery, other transport equipment (including aerospace), road vehicles, scientific and photographic, and mechanical machinery. In some sense, new economy, high value added sectors. Second, an intermediate group including miscellaneous finished manufactures, beverages and chemicals, which have gone through ups and downs. Finally, the low value-added sectors, such as crude materials, food, clothing, and material manufactures have fared well below the average. While sectoral shifts in manufacturing exports may also be related to a variety of factors unrelated to the exchange rate, it is likely that the strong real appreciation has hastened some of this restructuring through a differential impact on competitiveness and profitability.
United Kingdom: Export Growth: Cumulative Differential with Respect to Average
Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A003
Source: ONS; and staff calculations.10. In terms of competitiveness, the crucial issue is whether the strategies adopted by U.K. firms could be sustained in the long run were the exchange rate appreciation to persist. To the extent that productivity gains—including in tradable services—are made, the negative impact on the economy of real appreciation may be mitigated. Nevertheless, unless productivity improves on a sustained basis and wage differentiation allows for moderate growth or even reduction of manufacturing unit labor costs, further erosion of margins may lead to diminished investment expectations and erode the production base of the tradable sector in the long run.
References
Baldwin, Richard (1989), “Hysteresis in Import Prices: the Beach-head Effect”, American Economic Review, 78, 773–785.
CBI (2000), The Future of Manufacturing.
Dixit, Avinash (1989), “Hysteresis, Import Penetration, and Exchange Rate Pass-Through”, Quarterly Journal of Economics, 205–227.
Goldman Sachs (2000), “Technology and the New U.K. Economy: Following in the Footsteps of the United States”.
Haskel, Jonathan (2000), “What Raises Productivity? The Microeconomics of U.K. Productivity Growth”, Queen Mary, University of London, manuscript.
Laxton, Douglas, Peter Isard, Hamid Faruqee, Eswar Prasad, and Bart Turtelboom (1998), “MULTIMOD Mark III: The Core Dynamic and Steady-State Models”, IMF Occasional Paper 164.
Samiei, Hossein, (1994), “Exchange Rate Fluctuations and U.K. Manufacturing Exports”, IMF Working Paper 94/132.
This chapter was prepared by Angel Ubide-Querol.
Real effective exchange rate based on relative manufacturing unit labor costs.
This recovery took place despite the still high exchange rate of sterling. CBI survey data shows that, during 1996–97, the exchange rate was the main factor limiting export growth (see Figure 4). Afterwards, and despite the continuation of the appreciation trend of the sterling, the price effect seemed to fade and demand concerns appeared during the emerging market crises. Finally, as developed economies recover after the crisis, it seems as though exports were more responsive to demand than to prices. The evolution of the trade balance with the euro area is an interesting example of this phenomenon: the deficit widens dramatically until mid–1998, but then it recovers along with the expansion of demand in the euro area and approaches surplus by end–2000, despite the still weak euro.
Over 1995–99, GDP grew in France by an accumulated 9.5 percent, manufacturing by 7.5 percent and services by 10 percent. In Germany, GDP grew by an accumulated 7.2 percent, manufacturing by 2 percent and services by 13.5 percent.
The econometric evidence on price elasticities from export equations is mixed. One of the most recent estimates of trade equations for the United Kingdom are those of the Bank of England macroeconomic model. The results show that, in a single equation framework, both the short run and the long run price-elasticities in the export equation are not statistically significant, and basically result in exports depending on both inertia and external demand. Samiei (1994) also finds the short-term price elasticity to be non-significant, and finds evidence of a structural break before and after the ERM period. However, using a more robust panel estimation technique and identifying restrictions on long-run elasticities, Laxton and others (1998) obtain statistically significant coefficients in a panel of G–7 countries, with a parameter estimate of–0.45 for the short run price elasticity.
Export firms could adopt two different strategies: either a policy where firms set prices based on domestic factors in order to preserve profit margins, passing-through exchange rate fluctuations to foreign consumers and sustaining the firm’s ability to supply and invest; or a policy of pricing to market, whereby firms take prices in foreign currency as given and offset the effects of exchange rate movements by adjusting local currency export prices, trying to preserve market shares. Samiei (1994) argues that, traditionally, there has been “a tendency for U.K. exporters to use favorable exchange rate movements to improve profit margins rather than to strengthen their competitive position and boost foreign demand.”
By comparison, the rate of return for the whole economy was stable at about 11 percent over the period 1989–99.
A recent article by the ONS shows that U.K. firms were amongst the most profitable in the world during the mid–90s (see Economic Trends, n565, December 2000).
Normalized unit labor costs are calculated by adjusting productivity data for the impact of the business cycle.
