The UK’s Foreign Exchange Reserves and the value of Sterling

Last week was the worst for the pound for a year as holders of sterling sold it following the collapse of the talks between the Conservatives and Labour on how to proceed with Brexit.  On the foreign exchange markets, the price of a currency is determined by supply and demand and, if holders of sterling wish to sell it to buy euros or dollars, then the supply of sterling increases and the price falls. Simultaneously, given the state of political uncertainty, demand for sterling on the foreign exchange market fell, further weakening the value of the pound against other currencies. As a result, sterling dropped to $1.27, losing 1.85% of its value during the week.

Most forex transactions are made using the U.S. dollar, euro, pound and Japanese yen; although one might think that currency is mainly traded on the FOREX market to buy foreign goods and services, this is not the case. On average $5.5 trillion is traded each day but less than 5% of this is to buy goods and services. The majority is to purchase financial assets (e.g. foreign shares and government bonds and to place money into an overseas bank account) or to speculate about the likely movements of currencies to make a profit. Therefore, confidence in an economy is crucial in determining its value.

The UK’s reserves of foreign currency, currently standing at $137bn, are used by the Bank of England to protect the value of the pound on the foreign exchange market. The reserves, at their highest level for at least 21 years, are held mainly in US dollars and can be used to buy pounds on the foreign exchange market, thus increasing the demand for pounds and hence increasing the price, or rate of exchange of the pound against other countries.

According to the IMF, they grew 19% in the last quarter of 2018 because the government wanted to have them available in case they were needed after the originally-planned Brexit date. However if one compares the value of our reserves against the £420 billion of sterling traded daily by UK financial institutions one can see that, while the UK authorities might be able to nudge the value of sterling and slow down its fall, we do not have the resources to withstand a major fall in its value unless the government decides to borrow heavily overseas from foreign governments, banks and the IMF.

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Shopping not going too well for Sainsbury’s and Asda.

A typical UK family spends approximately 10% on food, with the figure being 4% higher for low income families. Therefore, what happens in the grocery industry is of significance to all consumers in the UK.

The proposed merger of Sainsbury’s and Asda would, if no changes are made in their operation, create a business which has 29% of the grocery market (Sainsbury’s 15% and Asda 14%), employ 343,000 workers (Sainsbury’s 187,000 and Asda 156,000), have 2,104 stores (Sainsbury’s 1,428, Asda 676) and revenue of £50.7bn (Sainsbury’s £28.5bn, Asda £22.2bn). The new business, which joins Britain’s second and third largest supermarkets together, would push Tesco out of first place

The arguments in favour of the merger focus on the economies of scale which the new firm would gain, such as bulk buying and marketing economies. It would allow it to build a stronger on-line presence and counter the competition from the discounters Aldi and Lidl and also from the entry of Amazon into the grocery market. According to the Chief Executive of Sainbury’s, consumers would benefit from price cuts of 10% on “everyday products”.

Elsewhere, there were concerns that the merger would reduce competition. The CMA has identified 694 areas of the country where it would fall because both Sainsbury’s and Asda have stores (either supermarkets or convenience stores) which currently compete. However, Sainsbury’s and Asda argue that the physical presence of stores is increasingly unimportant as more shopping is done on-line. Consumer groups and trade unions fear that the merger would effectively create a duopoly among the supermarkets (Tesco and Sainsbury’s/Asda) which would allow pressure to be placed on suppliers to lower prices, would involve redundancies as the new firm closed stores and sacked staff and lead to lower quality and higher prices.

Although their final report is not due until April, the Competition and Market Authority announced last month that the proposed merger  was likely to be against the public interest, leading to higher prices and a reduction in the range and quality of products. They have the power to block the deal or, if they allow it, to ensure that the two companies sell off a number of stores and allow another company to buy either the Sainsbury’s or Asda brand.

An Economic Update

Rising employment                   Falling unemployment       Low inflation                Rising pay

Forecast inflation increases    Falling productivity              Forecast job losses

Falling confidence                      Increasing balance of trade deficit    Rising household debt

Over the last two weeks there has been much economic data published, together with forecasts of what might be in store for the economy over the next few years. While some of what has been announced for the future is easy to assess, such as Honda’s announcement of the closure of its Swindon factory in 2022, some of the data is contradictory, so it is not easy to see exactly how we are doing. Furthermore, the picture is clouded by difficulty in distinguishing between temporary features due to Brexit uncertainty, such as businesses delaying investment decisions with the Head of Make UK, a body representing engineering companies, talking of a no deal as being “catastrophic”. There are also factors such as increasing household debt which might have a significant long-term impact on the economy.

On the optimistic side, the latest labour market figures are positive. Employment has risen in the last three months of 2018 and, compared to a year earlier, has increased by almost half a million, with most of the increase being accounted for by an increase in female employment. Unemployment remains at 4.0%, or 1.36 million people, the lowest rate for approximately 40 years; the employment rate (the percentage of 16 – 64 year olds in work) was at 75.8%, another record, and therefore the activity rate – those who cannot or do not wish to work such as students or those medically unable to work – has fallen to a record low. In addition, the number of vacancies has risen to 870,000, the highest ever recorded, with the increases being mainly in the service sector such as retailing.

The ONS has also announced the January inflation figures which show prices are now rising at 1.8%, down from 2.1% in December. This is partly due to the energy price cap and falling fuel prices, but economists are predicting that the fall below the government’s 2% target will only be short-term as increasing oil prices and planned energy price rises feed through into the CPI.

Because of the tightening labour market, it is not surprising that wages are increasing with the latest data showing an annual increase of 3.4%. Comparing this figure with the latest inflation data shows that real incomes are now increasing by 1.6%, the fastest rate since summer, 2016. However, in real terms, average pay is still £10 per week lower than it was ten years ago and, despite rising real incomes, consumer confidence is falling, as measured by the Household Finance Index. This is a measure which tries to predict changing consumer behaviour. It is based on monthly responses from over 2,000 households, chosen to accurately reflect the country’s income, regional and age distribution. Among items examined are changes in household income, spending and savings, job security, household debt and borrowing, inflationary expectations, house prices and confidence in the government.

A key negative figure for the economy is the low GDP growth, which was only 0.2% in the last three months of 2018 and 1.4% for 2018, the lowest increase since 2009. While household and government consumption were positive, a poor balance of payments and falling investment reduced growth. The combination of high employment, low investment and low growth in GDP explain the poor productivity data for the UK with output per person falling 0.1% last year.

However, one positive figure is the latest data on government borrowing which, for January 2019, was a surplus of £14.9bn. While January is always a good month, because of self-assessed income taxes, capital gains tax, corporation tax and VAT falling due in January, the actual taxes received were higher than previously predicted, and government spending increased less than anticipated, meaning the actual budget surplus was almost 50% larger than the forecast surplus for the month of £10bn. The improved figures mean that government borrowing for 2018/19 is now likely to be £22bn rather than the previous forecast of £25.5bn, the lowest figure since 2001, and the National Debt, at £1.8 trillion is forecast to be 82.6% of GDP, compared to 85.6% last year. Most importantly, the deficit is likely to be only 1% of GDP giving the Chancellor scope to cut taxes and increase spending to boost the economy yet still remain within the 2% figure he suggested as a ceiling.

 

 

 

 

 

 

 

Do we have a housing crisis?

Last week it was announced that an American businessman had bought a house in St James’s Park, near Buckingham Palace, for £95 million. As you might expect, the house has a pool, gym, staff quarters and private gardens. At the other end of the scale, the Institute for Fiscal Studies recently reported that 40% of 25 – 34 year olds are not able to afford a 10% deposit to buy the cheapest house in their neighbourhood. In London, approximately twenty years ago, 90% would be able to afford the deposit whereas today only 33% can afford the deposit. Because of the difficulty faced by people getting on to the housing crisis, newspapers have been talking about a housing crisis for some time.

A sign of the housing crisis is the high price of housing, signifying either excess demand or restricted supply. Focusing first on the demand for housing, for many years buying a house was an ideal way of building up wealth for potential homeowners, thus increasing the demand for housing. Not only did borrowers previously receive tax remission for mortgage payments, the price of houses increased more or less continuously and so one could borrow, knowing that when the mortgage was repaid, the increase in the value of the house would more than have covered the cost of the mortgage. More recently the Government introduced the ‘Help to Buy Scheme’ in 2013, (now extended to 2023) which lends, interest fee, up to 20% of the cost of a new build home (40% in London) to borrowers who have been able to raise a 5% deposit, meaning they only need a mortgage for 75% of the value. It has helped to finance the construction of 170,000 homes of which 140,000 have been purchased by first-time buyers. But it has been expensive, costing taxpayers nearly £8 billion since 2013, and providing considerable profits for house builders as demand increased more than supply, thereby pushing up prices. Another criticism has been that the scheme has not helped the low-paid since they have not taken as much advantage of the scheme as those with higher incomes. In addition, we are seeing that buyers of homes using the scheme who now wish to sell, have found that their property has fallen in value since future buyers are not eligible for the help to buy assistance. There have also been a number of suggestions to boost supply. These include allowing more building on green belt land and introducing measures (not yet introduced) to help older buyers down-size and therefore free up larger homes.

Why are we so concerned about declines in house building and house purchases? Apart from the social and political issues which result from people not being able to afford to buy their own house, having to pay excessive rents or sleeping on the streets, there are significant economic implications of a failing housing market. Firstly, if  building slows, bricklayers, electricians, plumbers, etc, lose their jobs and firms making bricks, providing carpets, furniture, ovens, fridges, etc, also experience a decline for their products and services and subsequently cut back on labour. As a result, incomes fall and, given the multiplier effect, the impact on the economy will be significant. It is worth noting that the multiplier effect will be large since so much of the expenditure involved in housing is domestic – i.e. there is relatively little leaked out of the economy in the form of imports.

Another way in which the housing market affects the economy is that a poorly-functioning housing market, causing high prices in booming areas, makes it difficult for firms to expand their labour force because workers cannot afford to move into the area. A final issue occurs via the wealth effect – the idea that households’ consumption is determined not only by their income but also by their wealth. For most people, their house is the main source of their wealth. Therefore, a booming housing market makes existing homeowners feel richer and they therefore spend more, believing that they have less need to save since their increasingly valuable house is adding to the value of their assets. Since the financial crisis, the housing market declined. When house prices dropped, people felt poorer and therefore felt the need to save more. This reduced consumption at a time when aggregate demand was already falling, thereby exacerbating the problems faced by the economy.

However, recently, after ten years of decline, the number of mortgages issued has increased and there was the highest number of first time buyers last year for 12 years, according to the government’s annual English Housing Survey, published in January. The increase was linked to the Help to Buy scheme, loans from parents and grandparents and a relaxation in the mortgage market. However we have also seen the slowest growth in house prices for six years, possibly down to Brexit uncertainty and last year receipts from stamp duty (a tax on house purchases) fell, largely because of the slowdown hitting the top end of the market.

Charles Dickens Revisited – A sad Christmas story for the Brexit Era.

The Chancellor of the Exchequer, George Philip Scrooge, or GP to his friends, distantly related to Ebenezer Scrooge, was at home in No 11 Downing Street, on Christmas Eve, 2019, writing a paper for the Prime Minister on what to do about the British economy, following the departure from the EU earlier in the year. Deep down he admitted to himself that the only reason he was doing this on Christmas Eve was because he was lonely. All his parliamentary friends (not that he had many of them these days) had left Westminster to go home to their families and even his neighbour, the Prime Minister, had gone to Washington to spend time with her friend Donald and his Russian acquaintances. GP also knew that he was very unlikely to get a visit from Santa this year. Not only were most presents held up at Calais because of the delays caused by border controls, Santa was having difficulty getting permission to bring his reindeer into the country because of new regulations affecting animals entering the UK and, if that wasn’t enough, his friends and relatives blamed him for the higher prices caused by import tariffs imposed on goods from the EU.

Gradually, despite his interest in the Treasury’s latest macroeconomic forecasts and the excitement of looking at all the negative numbers they contained, he started to feel sleepy, very sleepy. The next thing he knew, the room was full of people all keen to talk to him. The first, who looked well over 100 yet was wearing a very trendy hoody with a large letter K on the front,  started to talk to him about the need to raise aggregate demand, by cutting taxes and raising government spending in order to offset the fall in consumption and investment which had occurred early in 2019 as the UK economy crashed out of the EU after Parliament failed to ratify Teresa May’s plan and the subsequent “People’s Vote” resulted in an almost dead heat when 50.5% of the voters opted for a No Deal departure from the EU. One of K’s friends, a Canadian called MC, asked what he should be doing about interest rates since he had people telling him to cut them to boost the economy while others, due to go off skiing in the New Year, told him to increase them to boost the value of sterling, which had slumped after the decision to leave and was now at parity with the dollar. K was not too bothered about interest rates – he kept going on about being caught in something painful called the liquidity trap.

As soon as K and MC stopped talking, a new American voice piped up, with the letter L on his back, suggesting that what was really important was not to listen to K and his friends but to focus on the supply side of the economy and, in particular, on increasing incentives to work and raising productivity in the economy. L was illustrating his ideas on a napkin, suggesting that taxes should be cut, therefore encouraging people back into work and explaining that this would be self-financing, since government spending on benefits would fall and revenue would increase as the newly-employed paid taxes and spent more, increasing VAT and corporation tax receipts.

Suddenly GP awoke from his nightmare and his unwanted guests disappeared.  “I need a holiday” he thought said to himself and grabbed his laptop to start searching for a short break. He gave up on Europe pretty quickly because of the permit he would have to buy to go to the EU. Although it was only 7 euros, these days, following the fall in the value of sterling, 7 euros was a lot of money. He started to look at breaks in the UK. Driving was out because of the rising cost of fuel after recent oil price rises and the fall in the pound so it had to be a train journey, until he remembered that Crossrail had not been finished, HS2 had been scrapped because of rising cost estimates and the rest of the network were not running between Christmas and the New Year.  Back to the Treasury forecasts and looking forward to Xmas Day with the Queen’s Speech, while eating a Gregg’s turkey sandwich for lunch.

The UK’s current problems

Attention in the UK is focused heavily on Brexit and what might or might not happen in the next few months – will Mrs May’s deal get through Parliament? If not, will there be a new deal negotiated or will we leave with no deal? Will there be a second referendum or even a general election or both or neither? However it is worth looking beyond the short term and  considering the problems we face, many of which might have influenced the Brexit vote.

On a global scale, there is talk that another recession might be approaching (although to be fair, there is often talk of another recession approaching!) A possible cause is the rise in interest rates which have already happened in the USA and the UK and is likely to happen in the Eurozone during next year. The US rise has already started to cause problems for some emerging economies because money which moved into their economies as interest rates fell and QE reduced bond yields in developed countries, has moved into dollars to buy US government bonds or to be placed in interest-bearing accounts. In addition, the strength of the dollar has caused some emerging economies further problems since many of their loans and interest payments are denominated in US dollars. A further potential cause of a world slowdown is the decline in China’s growth rate. A growth rate in China of 6% adds the equivalent of Russia’s entire GDP to Chinese GDP each year so even a small slowdown has an impact on the world economy. There is a fear that, as China grows, the opportunities for continued, fast growth diminish so it becomes more difficult for them to rapidly expand. Nearer home, there is also concern about Italy’s high level of public borrowing and the possible implications of this for the euro.

In the UK, there has been much discussion about possible economic factors which influenced the vote in 2016.  One issue was the regional imbalance between London and the South East compared to the North of England, with the latter feeling that they were ignored by governments which focused their activities on the South. Infrastructure is poor in the North with lower transport per head than in the South, incomes are higher in the South with average London incomes being 2 ½ times those in the North East and, since 2010, London incomes have grown 20% while those in the North East have only risen 6%. Many Northern companies have moved their headquarters down to London and there has also been a move in skilled labour in the same direction.

Another issue was the falling real incomes which many workers have experienced since the financial crisis. Following the recession in 2008, average wages fell almost consistently in real terms until mid-2014. Although there has been some recovery, there are still major problems with poverty in the UK. The Joseph Rowntree Foundation reported this month that almost 4 million working adults were below the poverty line because their wages were so low, about half a million more than five years ago. This was based on the idea of poverty being people or families receiving less than 60% of the median income by household type (e.g. married with two children), adjusted for the cost of housing. The implication of their report was that, although unemployment has fallen significantly in the UK, many of the new jobs are low paid ones. (It is worth noting that these figures are not accepted by the government since they focus on relative poverty and uses a definition of poverty now updated).

A further issue has been the effects of a decade of austerity on voters. Not only is there increasing concern over the quality of public services (think train delays and NHS waiting times) but a recent report from the OECD points out that the % of GDP taken by taxation has risen to 33.3%, a 49 year high, and above countries like France (46.2%), Italy (42.4%) and Germany (37.5%), but below Japan (30.6%) and the USA (27.1%). The prediction for this year is that the tax burden will rise further and if correct, since 2009 the share of GDP taken by tax will have risen by 2.2% while the share taken by government spending will have fallen by 5%, hence people feeling that they are paying more but receiving less from the government. There has also been a perception that EU migration has imposed further strains on the economy – using the NHS, filling up schools, taking scarce housing, claiming Job Seeking Allowance and other benefits and taking jobs from UK workers (although these last two are contradictory!). The positive benefits of migration in terms of providing skilled labour and contributing tax revenue have not received the same attention.

While there is very little, if anything, which the UK can do to prevent the global problems mentioned above, it can take steps to tackle the issues specific to the UK. Solving these will place the UK economy in a much stronger position to withstand global shocks and to make the best of whatever Brexit outcome occurs and will be the focus of the next post.

Trade Wars

In an attempt to escape from the latest Brexit news, this week’s blog examines the trade war between the USA and China. Until recently, economics textbooks glossed over tariffs, quotas and protectionism; they were mentioned as possible approaches to improving a country’s balance of payments but it was accepted that although there were customs unions in existence, such as the EU, with a common external tariff (i.e. all products entering the union paid the same tariff, irrespective of where the goods entered the customs union, tariffs were not changed frequently as an economic weapon. This was because the accepted view among economists and (most) politicians was that world free trade was beneficial, allowing goods and services to be made  in the countries most suited to their production (lowest opportunity cost in economic terms) and then traded for products made overseas, thereby allowing consumers to benefit from lower prices and an increased standard of living.

However all of that has changed with the imposition of tariffs by the USA on Chinese goods and retaliation by China, followed by retaliation for the retaliation by the USA! The crisis began in July, after months of negotiations, when the USA imposed 25% tariffs on an initial $34 billion of Chinese goods, including machinery, electronics, cars and computer components such as hard drives.  China then retaliated and the following month the USA placed 25% tariffs on a further $16bn of Chinese goods which were matched by reciprocal Chinese tariffs on American goods such as cars. Then in September, President Trump imposed further 10% tariffs on $200 billion of Chinese goods and has threatened to increase this to 25% next year. China has retaliated with tariffs on $60 billion of US goods. The rationale for the American tariffs was two-fold – firstly that, according to President Trump, China had an “unfair” trade surplus in goods of $376 billion with the USA, thereby hitting American jobs, and secondly that China engaged in unfair trading practices, frequently involving foreign firms being forced to share their technology with Chinese ones.

The effects of the tariffs will depend on many factors. It is possible that businesses might find a way round the tariffs. For example, US soya producers have complained about the tariffs on their products but there is already evidence that they have been able to increase their exports to Brazil and Brazilian firms have exported to China. However many US businesses have expressed concern over the rise in costs of components imported from China and the effect they will have on consumer prices in the US. On the other hand, President Trump has argued that the tariffs will persuade US firms to produce more in the US to avoid the tariffs but others suggest that US firms will still produce overseas, where manufacturing costs are cheaper, but in countries other than China. A key factor will be the price elasticity of demand for the goods affected. This will determine whether producers can pass on the tariff,  whether they will have to absorb some or all of it and whether they will need to cut output with subsequent effects on output and employment.