For decades, economics textbooks argued that suddenly weaker currencies are a boon to growth, because they makes a country's exports more competitive or profitable on the global stage, which in turn boosts domestic production and employment.
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What if that theory no longer holds?
Economists and government officials are increasingly wondering if that effect is diminishing, especially among advanced Western economies with shrinking manufacturing capacity and supply chains increasingly interwoven with the rest of the world. The new idea is that much of the benefit from a falling currency is offset by the higher prices paid for components imported from overseas.
The U.K. is emerging as a test case for whether globalization has diminished the effect. Although its currency has been battered by the financial crisis, the Brexit vote to leave the European Union -- which took place a year ago June 23 -- and the country's fresh bout of political uncertainty, its exporting power hasn't responded as textbooks might suggest.
Chemicals made at Chemoxy International Ltd.'s factory in Middlesbrough are worth about 20% more in the export market after last June's fall in sterling, given the beefed-up value of the currencies used to buy those goods overseas. Higher costs for imported materials, however, all but erased that advantage.
"We have a huge interdependency on international markets," says Chemoxy Chief Executive Ian Stark. The company exports more than 60% of its products and imports about 85% of its chemical raw materials. A weaker pound, he says, "isn't revolutionary."
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British businesses ranging from car makers to food processors to lumber mills are discovering the same thing.
Adam Posen, president of the Peterson Institute for International Economics, and a member of the Bank of England's rate-setting monetary policy committee between 2009 and 2012, says the effects of currency moves on exports have faded over time. After the financial crisis in 2008, a big sterling depreciation didn't result in the pickup in exports "we would have expected," he says.
"You just don't get as much bang for your pound as you used to," said Mr. Posen.
Whether or how the relationship between a currency's strength and economic growth still holds has ramifications for international politics. In the U.S., manufacturers have long complained about the impact of a strong dollar. President Donald Trump has accused Japan and China of keeping their currencies artificially low, hampering U.S. exports.
In 1992, the pound fell by around 11% between September and the end of that year after the U.K. crashed out of the European exchange rate mechanism -- a precursor to the euro that required a stronger pound than the government could sustain. The U.K. economy then went on an export tear, which turned a trade deficit into a five-year surplus and jump-started a recovery.
The pound fell by nearly 25% against the currencies of its major trading partners between 2007 and 2010 and never recovered, sparking optimism in government that exports would rise. In 2012, then-U.K. Treasury chief George Osborne targeted an increase in exports to GBP1 trillion by 2020, from GBP499 billion that year. By the end of 2016, exports had risen to just GBP547 billion.
When the currency took another beating after the Brexit vote, the impact was similarly muted. Car maker Aston Martin, which exports 80% of its vehicles, helps show why. Before Brexit, when the pound traded at $1.50, sports cars sold in New York for $150,000 would bring home GBP100,000. With the pound now at $1.27, such sales bring an extra GBP18,000. But over half the car's components must be bought from abroad, blunting the effect.
"During the past decade, a lot of auto suppliers have moved offshore," says Aston Martin Chief Executive Andy Palmer. "In consequence, you don't get the benefits."
In recent months, sterling has recovered from its post Brexit lows and is currently down 15% against the dollar and 13% against the euro. Analysts remain pessimistic about the currency as Britain heads for divorce from its largest trading partner, the European Union. The pound fell 1.7% on Friday after Prime Minister Theresa May's ruling Conservative Party failed to secure enough seats in a snap general election to alone form a government.
Global economists are debating how much exchange rates affect trade for developed nations. Two recent papers, from the World Bank and the Organization for Economic Cooperation and Development, found movements in exchange rates had a declining impact on trade in several advanced economies.
The OECD paper said a plunge of sterling in 2008 and the yen's decline against the dollar in 2012 had little impact on trade. The study said evidence suggested companies had become more embedded in global supply chains. Between 1995 and 2011, the import content of exports rose from 14.9% to 24.3% among OECD nations.
In May, the Bank for International Settlements published new mathematical models for estimating real effective exchange rates, one measure of the strength of a currency. It said without taking into account deep global supply chains, standard exchange-rate models "are increasingly becoming obsolete."
Other economists have resisted the idea, including a team at the International Monetary Fund, which came to a different conclusion and found "little evidence of a weakening in the effects of exchange rates over time."
In its analysis, the IMF suggests a significant currency depreciation -- where currencies weaken by at least 13% in advanced economies, or 20% in emerging ones -- results in a 10% rise in export volumes over five years.
The IMF had some caveats. The paper argues the impact of a weaker currency is strongest when the economy isn't running at full capacity, for example following a recession. It also suggests that financial crises dent companies' ability to take advantage of a depreciation, because of the lack of available credit.
"In general, however" the authors conclude, "the role of flexible exchange rates in facilitating the resolution of trade imbalances remains significant."
Since Britain's vote to leave the EU, consumers abroad have been buying more British products. In the six months through April, the most recent month for which the U.K.'s Office for National Statistics has published data, goods export volumes increased 3.1% from the year-earlier period. Over that same period, import volumes rose even more, by 4.9%.
"We are not yet seeing a notable narrowing of the [trade] deficit," the Office for National Statistics noted in its latest report.
For some exporters such as Scotland's whisky industry, the pound's fall has been pure good news because most of what goes into a bottle of whisky is produced locally. The Scotch Whisky Association says exports increased 4% last year to over GBP4 billion.
Most U.K. manufacturing industries, however, can no longer rely on domestic supply chains. In 2015, manufacturing represented 9.8% of the U.K.'s gross domestic product, down from 14.7% in 2000. In the U.S., by comparison, manufacturing represented 12.3% of the GDP in 2015, and 15.5% in 2000.
As U.K. manufacturing declined, service industries grew and now are responsible for 79% of GDP. Those industries are less sensitive to changes in exchange rates. In the services sector, the U.K. runs a trade surplus that grew to 5.4% of GDP at the end of last year. For London's huge financial sector, sterling's tumble has little benefit because business is often denominated in other currencies and demand for service industries tends to be less price sensitive.
Trade in goods, however, is an entirely different story. The U.K. deficit in that area has ballooned from 1.6% of GDP in 1995 to 6.4% last year. It has kept rising despite imports becoming more expensive and exports more competitive. This year's goods deficit, through April, is GBP42.8 billion, excluding oil and particularly volatile items such as aircraft.
Some economists have long been sceptical of the idea that trade can be shifted by currency depreciation in the longer term. As a currency weakens, the price of imported goods rises, raising inflation. Also, they say, structural problems, such as weak productivity and competitiveness, are often causes of trade deficits, which depreciation cannot address and may even prevent a country from tackling.
"Don't believe that Britain is going to depreciate itself out of its current account imbalances," says Willem Buiter, chief economist at Citigroup Inc. and a former member of the Bank of England's rate-setting committee.
To make matters worse, Britain, like other developed economies, has become so reliant on imports to stock its stores that a weaker pound has increased inflation, making life more expensive and curbing consumer spending.
Britain now imports more than 60% of its fish. The pound's fall triggered a 15% overnight jump in prices for the crates of cod and haddock that Mike Woods buys from the docks of Grimsby, in northern England. That cost his food processing company, Albert Darnell Ltd., an additional GBP15,000 a week.
Like other food manufacturers, Mr. Woods is passing on that increased cost to consumers. Fish and chips have become more expensive at the St. James Fish Restaurant in the center of Grimsby. "We get people complaining now," says waitress Eve Barrow.
Retail prices of cars, shoes and potato chips all have risen. Last October, an increase in the price of Marmite, a sticky yeast spread beloved by the British, triggered front-page headlines. Economic growth in the U.K. slowed in the first quarter of the year, with higher prices hurting consumer spending.
While more expensive imports should present opportunities for British manufacturers and suppliers to step in, it will take time for industry to adjust.
Around 80% of the timber used in U.K. construction is imported, mainly from Scandinavia, according to the Timber Trade Federation. It isn't easy for Britain's construction industry, which is responsible for around 7% of GDP, to shift quickly to domestic suppliers.
Keith Ainslie of James Jones & Sons Ltd, the U.K.'s largest sawmill, says the company's main plant in Lockerbie, Scotland, is already "working full tilt." Processing more logs would mean building another sawmill, a roughly GBP60 million project that would take around three years to get up and running.
Nature also acts as a limit. "We're constrained by the availability of trees," says Mr. Ainslie. It takes 40 to 55 years to grow a crop of trees to maturity.
Still, some companies see the pound's fall as an opportunity to expand. Mark Driver is setting up Rathfinny Wine Estate on England's southeastern coast. The price of equipment he needs to import, such as wine presses and bottling machinery, has increased since Brexit.
Nevertheless, the former hedge-fund manager thinks the pound's decline is good news. By 2025, he says, he aims to be producing around one million bottles of sparkling wine a year and sending half of that overseas.
A "weaker pound helps us," he says. "Long term, I think it's really positive."
(END) Dow Jones Newswires
June 11, 2017 15:08 ET (19:08 GMT)