Since the referendum in 2016, sterling has fallen from £1 = 1.27 euros to 1.16 euros today and from $1.45 to $1.32, having dropped to 1.1 euros and $1.25 earlier in the month, and there is talk about further falls depending on whether we do or do not reach an agreement with the EU. For those looking for a longer perspective, £1 was worth $4 after the Second World War, dropped to $2.8 when sterling was devalued in 1949, then $2.4 when it was devalued again in 1967 and it fell once flexible exchange rates were introduced during the 1970s.
Economic theory predicts that the fall in sterling would lead to an improvement on the current account of our balance of payments as exports of goods and services increased because of their fall in price while imports, now more expensive, dropped as UK consumers and businesses sought cheaper alternatives. The size of the changes in imports and exports are determined by the price elasticity of demand, summed up by the Marshall Lerner condition which states that a devaluation or depreciation of the exchange rate will improve a country’s balance of payments if the sum of the price elasticities of demand for imports and exports are greater than one. The improvement is not immediate because demand for imports and exports is inelastic in the short term, giving rise to the J Curve effect where, following devaluation, a country’s balance of payments first deteriorates and then improves. Even if UK firms do not cut prices in overseas markets, the higher profits they are now receiving from exports should encourage them to devote more resources to their export markets.
Therefore, we should, by now, be experiencing a significant improvement in the balance of payments but this has not happened. In the time following the fall in sterling, the quarterly deficit in goods increased from £31.2bn (March – May 2016) to £34.7 (September – November 2018). So why has the balance of payments not improved? Firstly, there is recent evidence that some companies are stockpiling imports (both components and finished products) in case of a disorderly Brexit. Another current issue has been the relatively slow GDP growth in UK export markets which has reduced the demand for our products.
There are two more significant reasons for the failure of our trade balance to improve and these cast doubt on the validity of using devaluation to improve one’s balance of payments. Firstly, because of globalisation, supply chains are highly integrated, with UK firms needing to import far more components to manufacture products than twenty years ago. Therefore, exporters will find that, rather than being able to cut their prices by the full extent of the drop in the value of the currency, they will have to take account of the higher costs of their imported components and raw materials, thus reducing the beneficial impact of devaluation. Secondly, the validity of devaluation depends on the price elasticity of demand and, increasingly, non-price factors, such as marketing and reliability, are becoming more important. Unfortunately, as Brexit nears, short-term doubts over its impact on such things as delivery dates and the ease of obtaining spare parts, will not help boost our exports, irrespective of the exchange rate.