Don't be surprised if growth slows significantly next year
The risk is that the hit on the real economy from exchange rate appreciation occurs as rate rises are biting and windfalls are fading from view
Thursday 05 June 1997
In the current environment talk of a hard landing looks misplaced. However, we can see reasons why growth could slow sharply next year, surprising a consensus which is conditioned to believe the boom times have returned.
It is understandable if many commentators think the strength of the pound will not prove much of a hurdle for growth. Despite more than a 20 per cent rise in the exchange rate, export volumes appear to be holding up relatively well and the UK's trade position has yet to deteriorate significantly. This will give the Bank of England even more reason to raise interest rates in defence of the inflation target.
However, to paraphrase monetary ideology, the exchange rate affects the economy with "long and variable lags". Conventional thinking seems to be that sterling strength is no substitute for higher interest rates in slowing the economy - the manufacturing sector may be hit but this would be dwarfed by the strength of services. We would caution against such a sanguine view on the role of the currency.
In our view, the relationship between the exchange rate and the economy has changed. Increasing global competition has led to UK exporters being much more price takers in world markets. Profit margins now do more adjusting to a change in the exchange rate. The chart shows what a close relationship there has been between the exchange rate and sterling export prices. Currency depreciations tend to be associated with rising sterling export prices and higher profit margins. Currency appreciations are associated with falling sterling export prices and lower profit margins.
Sterling export prices are only now beginning to come under pressure. However, because of contracts and recognition lags in 1992 there was an interval before the devaluation led to higher sterling export prices. Looking at the net export performance, one would be forgiven for thinking the 1992 devaluation did little to improve UK growth prospects. In reality, the currency itself proved very helpful, but the growth effects were delayed until 1994 and 1995. The massive leap in exporters' profitability brought a delayed but powerful supply-side push into export markets.
We find it unrealistic to assume that more than a 20 per cent appreciation in the exchange rate will not hit profits hard. Gross trading profits of all companies recently decelerated significantly, partly on the back of a pick-up in whole economy unit labour costs.
There also seems to be a degree of "money illusion" built into many analysts' company profit projections. Assuming inflation averages 2.5 per cent a year going forwards, nominal GDP will average at best 5 per cent a year (2.5 per cent inflation plus 2.5 per cent trend growth). Over the longer term, earnings will have difficulty beating that benchmark. Even without the rise in the exchange rate, profit downgrades would be in the pipeline.
The risk is that the hit on the real economy from the exchange rate appreciation occurs as interest rate rises are biting and windfalls are fading from view. We can see from the experience of the US that companies are now much quicker to address a squeeze on margins and a slowdown in order books. Next year would be a different scenario if unemployment started rising again in the UK. Household income growth, a key driver for consumption trends and the housing market, could decelerate sharply.
On a more general point, there seems little risk of a consumer boom without a decisive fall in the saving ratio. This is as high now as in recession. Part of the explanation for the high saving ratio lies with the labour market. Despite falling unemployment and evidence that average job tenure has picked up a little since recession, survey evidence suggests that job security has declined to record lows.
In the past, falls in unemployment were associated with a declining saving ratio. However, in the past falling unemployment did not coincide with rising job insecurity. If the UK continues following the US model, employee morale is unlikely to continue deteriorating forever. However, by historic standards it could remain very low.
Work we have done at Dresdner Kleinwort Benson has identified the importance of equity withdrawal from the housing market for the consumer boom of the 1980s. Official data confirms there is no evidence yet of equity withdrawal picking up. This is not so surprising. In the past there has always been a long lag before rising house prices led to equity withdrawal. A reduction in negative net equity might lead some individuals to repay debt at a slower rate or to stop repaying debt. However, others may use any improvement in income prospects to reduce their debts.
The Bank of England's task has been made harder by the polarisation that seems in evidence in the labour and housing markets. The top end of the housing market has recovered sharply but the national performance is not so impressive and turnover is relatively very low. Moreover, real wage growth per employee remains relatively low. Excluding the bonuses paid to the finance sector, real wages per employee are growing by not much more than 1 per cent a year, compared to the long-term average of 2 per cent.
It is the task of forecasters to try and identify structural breaks, which may have caused relationships which held true in the past to break down. We can identify several. We would not be surprised if economic growth slowed from over 3 per cent this year to under 2 per cent next.
The author is UK economist and director at Dresdner Kleinwort Benson
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