• Home ::
• Fundamental ::
• Analysis Reports ::
• Economics Weekly

• Send
• Print
• Add To
• Rss

Economics Weekly

Will the fall in the UK's exchange rate boost manufacturing?

Tue, Apr 22 2008, 07:13 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Despite all the gloom, UK manufacturing output is holding up remarkably well
Surveys show that firms’ orders are strong and business confidence rising. In this note, we identify three main reasons why this seems to be occurring, concluding that a weaker currency, fast growth in the emerging markets and rising productivity in manufacturing may be the main factors behind a surprisingly good performance by the UK manufacturing sector in the last two months.

In recent publications, we have highlighted that growth in the emerging markets is still very strong. A few weeks ago, the IMF downgraded its forecast for global economic growth in 2008 from 4.8% to 3.7%, but reduced growth in the emerging markets by just 0.2% from 6.9% to 6.7%. This pace of growth will clearly help UK manufacturing; exports to developing countries accounted for 22% of total UK exports in 2005. Interestingly, exports to China, India, Russia and Brazil, the largest block in terms of population and growth, accounted for just 4% of UK manufacturing exports that year. So what is important for UK exports is the rate of growth of the developing countries as a whole, which is what is holding up so well.

Of course, the ability to take advantage of overseas growth is down to the UK’s exchange rate and its productivity
Recently, UK manufacturing productivity has held up very well in the context of a weaker bias to economic growth and continuing high employment levels, and is rising towards the average since 2000, see chart a. But the biggest change has been in the exchange rate. Chart b shows that the pound’s trade weighted index (TWI) has fallen by about 12% since its peak last year. Chiefly responsible for this fall in the TWI has been the pound versus the euro - the euro zone accounts for about 55% of UK exports.

To us this is one of the major reasons why UK manufacturing is holding up so well. To see why, we have plotted the TWI and the pound against the euro back to 1990, in order to pick up the last time that there was such a sharp fall in the UK’s exchange rate. That was in September 1992 when the pound was forced out of the Exchange Rate Mechanism (ERM). Chart b shows that the TWI’s steep fall, then as now, was dominated by sterling's fall against the euro. This fall in the TWI boosted UK manufacturing firms’ export orders, see chart c, though with a lag. The experience after the pound's ERM exit in 1992 suggests that the time period between a fall in the TWI and a rise in exports is quite short, and the effect of the boost to manufacturing orders lasts for about 2 years.

Given the recent fall in the UK’s TWI, therefore, we expect that export orders will be boosted for at least the coming year and a half. We have plotted what this would look like for UK export orders if the starting point was from the sharp fall in the TWI last year, using the 1992 experience as a guide. Interestingly, what this chart shows is that the UK is currently starting off with a better order book position than in 1992. This may be down to fast growth in the emerging markets, from the industrial spread of growth or from stronger productivity in the key areas where UK exports are rising fastest. But the fact is that the implication from the experience of 1992’s sharp fall in the UK’s TWI is that UK export orders will remain strong, or at least very competitive, well into 2009. Of course, with a global economic slowdown, this competitive position may only mitigate a decline in exports not boost it, but only time will tell whether that is actually the case or not.

But what impact will all of this have on manufacturing output?
We have also, in chart e, plotted what the course of manufacturing output was like in 1992 after the pound's exit from the ERM, and compared it to the latest actual manufacturing output data. Our calculations suggest that, if manufacturing output followed the same path as in 1992, then UK output growth this year will be 2.5% and 2% in 2009. Our forecasts are more modest than that, 1.2% growth this year and 1.4% in 2009. These forecasts are well above the current consensus view, as published in April this year, of just 0.2% for 2008 and 0.7% in 2009. If we are right, this implies faster economic growth than the consensus, brighter prospects for investment spending and fewer corporate defaults than many are currently forecasting. It also implies that a move to a steeper yield curve is likely soon, and for official interest rates not to be cut as aggressively as the consensus currently projects.

• Download Full Economics Weekly

Published on  Tue, Apr 22 2008, 07:25 GMT

Archive

• UK manufacturing to avoid recession
  Published On Tue, Jul 15 2008, 06:35 GMT
• How vulnerable is the UK corporate sector to a slowdown?
  Published On Tue, Jul 8 2008, 07:17 GMT
• Scenarios highlight risk of UK recession
  Published On Tue, Jul 1 2008, 07:05 GMT
• Will UK official interest rates be raised this year?
  Published On Tue, Jun 24 2008, 06:57 GMT
• Will the BoE Governor have to write an open letter?
  Published On Fri, Jun 20 2008, 10:01 GMT

[ View All ]

• More Reports from this Author
• More Reports from this Contributor

Lloyds TSB  | Faryners House, 25 Monument, London EC3R8BQ
http://www.lloydstsbfinancialmarkets.com/doc/fms/financial_markets.htm | Sarah.Pedder@LLOYDSTSB.co.uk