Bank of England Highlights Benefits of Currency Depreciation

The Bank of England (BoE) released its “Inflation Report” on November 11, 2009. This was my first time ever reviewing the report and watching BoE Governor Mervyn King in action as he coolly parried with reporters during the press conference covering the report.

The latest Inflation Report frequently references the benefits of the depreciation of sterling (I refer to the currency as the British pound):

1. Increased competitiveness of U.K. exports
2. Higher import prices that channel consumption to domestic products
3. Stable overall inflation in 2009

The pound peaked against its currency basket in 2007. The BoE uses that milestone as its most important reference point. However, the improvements mentioned above did not occur until after the bounce from the bottom in March of this year. During this time, the pound actually appreciated sharply, as much as 13%, and it has only come back down in the past several months. The British pound has topped out against the U.S. dollar and is stuck in a 5-month price range (see FXB for example).

The BoE also forecasts steady appreciation in the pound of around 6% over the next three years. The currency chart below comes from page 19 of the Inflation Report:

British pound expected to appreciate over the next three years

If this forecast comes to fruition, I have to believe that the U.K. will not see much more of the benefits described above (unless there is some very long lag effect from 2008’s depreciation!). Indeed, I strongly suspect that the BoE will work to prevent this appreciation (I have posted indicators that tell me the BoE wants the pound to go lower from here).

Page 25 of the Inflation Report provides a very telling chart showing the approximately inverse correlation between between the pound and the U.K.’s export market share.

Strong sterling helped drive down U.K. export market share for almost 10 years

Note well that the U.K.’s export market share actually continued to decline during the largest part of the British pound’s depreciation. The BoE speculates that some exporters used currency depreciation to boost profits rather than reduce prices in foreign markets. The BoE does not provided any additional insight into this apparent anomaly given its fixation on the idea that a 25% drop in the currency since the peak has driven a heaping of economic benefits. Since the data above is aggregated annually, the BoE does provide additional insight into how the relationship has played out in 2009:

More recently, contacts of the Bank’s regional Agents have noted a modest recovery in export demand, particularly from Asian economies. Surveys of export orders have picked up a little in Q3, and, according to the CBI, optimism about manufacturing export prospects over the next year rose to its highest level since 1995. Monthly trade data for July and August also suggest that goods export volumes picked up in Q3. And there are already signs that the UK export market share may have been boosted by the decline in sterling: the cumulative fall in total world trade since the start of the recession is slightly larger than the cumulative fall in UK exports over that period.

Again, it seems the benefits of the weaker currency are coming only after it has already appreciated and stabilized.

The inverse relationship between the currency and import prices is very clear and quite dramatic. The Inflation Report provides the following graph of the exchange rate in the currency reported inversely to import prices (page 35):

U.K. import prices (inversely) correlated to sterling

Page 44 summarizes the overall benefits of this boost in import prices:

The lower level of sterling should aid the rebalancing of the UK economy. That will be an additional factor bearing down on UK imports, along with weak domestic demand. The depreciation should also boost the share of world trade that UK exporters are able to capture, although that could take time.

Overall, it seems that there is some lag in the benefits the BoE expects from currency depreciation. Perhaps the severity of the recession distorted and delayed the typical benefits as demand across the globe contracted sharply. Either way, I believe the BoE has once again made it clear that it prefers that the pound weaken further from current levels. Governor King even emphasized that the BoE has “a complete open mind” on whether to expand the current program of quantitative easing (QE).

Finally, Governor King also addressed a reporter’s expressed concern over Fitch’s repeated threat to downgrade the United Kingdom’s AAA-rating if another major stimulus package passes. This reiteration caused the pound to fall very briefly. Governor King was quite blunt by insisting that the warnings of ratings agencies should not be taken at face value. He followed up by claiming that the U.K. is completely capable of getting its debt under control, and he pointed to the budget passed last spring that already includes significant fiscal consolidation.

An actual ratings downgrade will certainly send the pound hurtling downward, but such an event is apparently not a preferred mechanism for depreciating the currency.

Be careful out there.

Disclosure: no positions

Comments

[bob adamson]

Currency manipulation remains one of the last tools remaining to countries to protect their domestic markets and penetrate the markets of others.

A major triumph over the next couple of years would be consensus amongst the major trading nations for the realignment of exchange rates of their currencies to more accurately reflect sustainable trade patterns. The danger is that competitive devaluations will begin instead.

2009 Nov 25 01:18 AM

[Moon Kil Woong]

Yes the preferred method for depreciation is the government making and spending more $ than it has. In many ways ratings downgrades are the only real method for protecting the people from their government's ill fated budgetary actions. On that note, lowering the rating on the US dollar would do the US citizen a world of good since nothing else seems to be able to shock the US into fiscal sanity.

2009 Nov 25 03:28 AM

[Dr. Duru]

Agreed. We are still running the risk of competitive devaluations despite the promise of the G20 not to do it.

Thanks for the comments everyone.

On Nov 25 01:18 AM bob adamson wrote:

> Currency manipulation remains one of the last tools remaining to
> countries to protect their domestic markets and penetrate the markets
> of others.
>
> A major triumph over the next couple of years would be consensus
> amongst the major trading nations for the realignment of exchange
> rates of their currencies to more accurately reflect sustainable
> trade patterns. The danger is that competitive devaluations will
> begin instead.

2009 Nov 25 01:47 PM