UK is sinking deeper into the red

The recent trade surplus with continental Europe has led some analysts to believe that the strength of sterling has not been as damaging as first thought.

Recent trade statistics have thrown up some surprising trends in recent years which have led some analysts to conclude that the pound is not as overvalued as previously thought, and business surveys are exaggerating the problems caused by the euro’s weakness.

Despite the weakness of the euro against the pound, export volumes to euroland have grown strongly, and the UK’s trade account with the zone has recorded a surplus in recent months. However, in contrast our trade balance with the rest of the world has deteriorated significantly.

Some of the explanation for this can be found in the strength of world markets, where the level of demand can be just as important to exporters as currency values. A combination of improved productivity and an acceptance of lower margins has also allowed manufacturers to sell increasing volumes of goods abroad, despite the pound trading well above what they regard as a competitive rate. Yet two conclusions emerge from our analysis of official data.

Less spending on imports

The first is that slower growth in Britain than in the rest of the European Union since the start of 1999 is mainly responsible for the recent surplus. That is simply because with GDP growing less quickly here, we have been spending less on importing goods and services from our European rivals. They, meanwhile, have been enjoying mounting prosperity, so they have been spending more on everything, including goods from the UK. Hence the trade surplus.

Despite its reputation for stodgy growth, the euro-zone has expanded faster than the UK since the end of 1998, more or less coinciding with an improvement in the UK’s trade balance from a deficit of £2.6bn at the start of 1999 to a small surplus today.

But if the two areas had been growing at the same rate, the deficit would have widened.

The second conclusion is that manufacturers are adjusting to the higher level of the pound against the euro and will continue to do so.

However, the consequences of this will not necessarily be positive for either our trade account or our manufacturing base, as the trade statistics seem to confirm what anecdotal evidence has been telling us for some time. Not only are manufacturers increasingly sourcing components for their products from cheaper locations, but some are encouraging suppliers to do so as a major part of the ‘roadmap’ to the cost reductions that they are seeking from them.

The evidence supporting this comes from geographic trade patterns. While exports to the European Union and to the rest of the world have been growing at relatively similar rates, imports from outside the EU have been increasing by more than three times that from the EU itself.

Since 1997, the UK’s deficit has increased strongly with two economic regions, the OECD and Rest of World. Annualising the data for the first 10 months of last year shows the deficit increasing from £3.8bn to £7.1bn for the OECD, and from £3.8bn to £15.3bn for Rest of World.

More detailed but less contemporary information from official data shows the largest increase in the deficit between 1997 and 1999 has been with Asian countries. After stabilising at around £4.5bn for most of the 1990s, this deficit ballooned from £4.7bn in 1997 to £15.9bn in 1999. If the Asian deficit had remained at its 1997 level, our goods deficit with the world would have increased from £11.9bn to £15.7bn in 1999 rather than the actual £26.8bn.

Another set of figures also bolsters the story of manufacturers making increasing use of cheaper supplies of components from parts of the world where costs are lower. Looking at the volume of goods imported uncovers two striking trends. The first is that consumer goods, the most price-sensitive category, are getting harder to sell abroad. They have shown the largest fall in sales volumes, slumping by 5% since 1997 compared with growth of 50% between 1992 and 1997 when a cheaper currency made life much easier.

Since 1997, the largest increase in imports has been in intermediate goods such as engineered components or systems, which have increased at an annual rate of 21% compared with 14% overall. They have also experienced the fastest acceleration over this period. In addition, we are also becoming more dependent on imports for the capital goods that underpin our manufacturing capacity.

Shifting costs

The statistics seem to suggest that, individually, manufacturers are pursuing the strategy that makes best sense for their company — reducing their exposure to the strength of sterling by moving a chunk of their costs to cheaper locations. Collectively, however, their actions are likely to create less favourable outcomes for the manufacturing base and for the country as a whole. These include the loss of skills and expertise, and a widening trade deficit. While the loss of some production activities, particularly at the lower value end, is inevitable, the current trend looks dangerously fast.

As a result, there must be questions about whether higher value added activities can replace the disappearing ones quickly enough, and also whether the ongoing loss of skills and expertise will undermine the much-needed shift up the value chain.

Stephen Radley is chief economist, Engineering Employers’ Federation