Funding The Deficit - The Big Test For The Pound

26/9/2017 Funding the deficit: the big test for the pound
Buttonwood’s notebook
After the Brexit vote

Funding the deficit: the big test for the pound
Britain’s current-account deficit was funded by foreign investors attracted to it as an
international hub. Will the pound have to fall a lot to keep the flow coming?
Buttonwood’s notebook Jul 7th 2016 | by Buttonwood
THE pound has been the biggest post-Brexit casualty in the financial markets. It has
fallen from almost $1.50 to around $1.30 against the dollar; less so against the euro
which itself has been dragged down by Brexit worries. The immediate impact for
British citizens is a cut in their standard of living; it costs more to buy goods from
abroad, whether it be imported commodities or foreign holidays.
https://www.economist.com/blogs/buttonwood/2016/07/after-brexit-vote-0 1/4
Of course, currency depreciation can be a very

useful tool for countries when they have become
locked in to an overvalued exchange rate. Many
people will recall Britain’s departure from the
Exchange Rate Mechanism in 1992 when the
economy perked up quickly and the inflationary
impact was limited. But the circumstances were
very different; interest rates were 12% and were
brought down rapidly while there was a lot of spare
capacity in the economy (unemployment was
10%). Now interest rates are just 0.5% and
unemployment is 5%.
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Chicago accounted for 22% of a nationwide account deficit. At around 7% of GDP, this
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deficit is not just a peacetime record, it is
bigger than the shortfalls seen in World
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War One (but not WWII). This means that
Britain has to attract foreign capital; it has
been very successful in doing so via foreign direct investment (FDI). But that was,
in large part, because of Britain’s place as part of the EU. Last year, a survey by Ernst
& Young (http://www.ey.com/UK/en/Issues/Business-environment/2015-UK-
attractiveness-survey) reported that:
“With 72% of investors citing access to the European single market as

important to Britain’s attractiveness, the referendum has the potential to
change perceptions of Britain dramatically, posing a major risk to FDI. Our
survey indicates that 31% of investors will either freeze or reduce investment
until the outcome is known.”
All this has now been thrown into doubt. Of course, one element of the Brexit
campaign argued that Britain could become more open to international investment
outside the EU; a kind of Singapore of Europe. However, as this blog pointed out
(http://www.economist.com/blogs/buttonwood/2016/06/eu-referendum) before
the vote, this camp sat uneasily with the more nativist, anti-globalisation and anti-
immigration side of the campaign. Until the outcome of the post-Brexit
negotiations become clear (and the talks may not even start until next year),
investors may hold back. Indeed, when it comes to the property market (one source
of FDI), there are signs that investors have already done so
(http://www.economist.com/news/business-and-finance/21701736-first-concrete-
signs-post-brexit-financial-stress-british-property-funds) .
As with everything in economics, things can get back into balance at the right price.
The pound can fall so that British assets are so cheap that they seem attractive. But
ASR argues this may require a prolonged decline to cheap levels; they estimate that
fair value for the pound/dollar rate is around $1.42. Eliminating the deficit could
require the pound to fall to parity with the dollar.
The pound did get almost that low in the mid-1980s (that was largely down to a
soaring dollar, rather than any great British problems). Such a fall would drive up
inflation significantly, squeezing living standards (the problem that may have
inspired some voters to back Brexit in the first place).
It would, of course, be good for exports. But as the chart shows, Britain has already
seen one big depreciation in the pound since 2000. It narrowed the current-
account deficit for a while but the effect was short-lived. Recent evidence does not
show that currency depreciations lead to a big gain in market share for exporting
nations. The first issue is that world trade is growing fairly sluggishly
(https://www.wto.org/english/news_e/pres16_e/pr768_e.htm) . The second, as ASR
points out, is that companies may decide not to cut their prices in foreign currency
terms but to take the higher foreign currency receipts (in domestic currency terms)
as extra profit.
A third issue is that globalisation means that business is conducted through “value
chains”, in which products are assembled or distributed in many markets. These
chains take time to assemble and companies are unlikely to unpick them because
of currency shifts. This paper published on Vox

(http://www.voxeu.org/article/limited-role-exchange-rates-export-
competitiveness) explains that:
“By disentangling the impact of exchange rate changes on trade results, we

have shown that the underlying assumption of the ‘currency wars’ discussion –
that devaluations bring about substantial export gains – may be severely
flawed. Non-price/non-exchange rate factors often appear to explain the lion’s
share of export outcomes, and this is particularly the case when exports are
measured in value-added terms. ”
Indeed, it is worth noting that a deficit can fall in two ways; a rise in exports or a
decline in imports, thanks to a collapse in domestic demand (as in 2009). That
route tends to be more common. But it won’t be what voters thought they were
getting as they clearly didn’t believe the warnings of economists before the vote.
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26/9/2017 Funding the deficit: the big test for the pound

After the Brexit vote

Buttonwood’s notebook Jul 7th 2016 | by Buttonwood

Of course, currency depreciation can be a very

“With 72% of investors citing access to the European single market as

of currency shifts. This paper published on Vox

“By disentangling the impact of exchange rate changes on trade results, we

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