Publication - Brexit and the pound - speech by Ben Broadbent - Speech given by Ben Broadbent, Deputy Governor Monetary Policy Imperial College, London 23 March 2017
Introduction and summary
The vote to leave the EU led to a big drop in sterling’s exchange rate. One consequence is a rise in import prices and a squeeze on households’ real income. We may already be seeing the impact of that squeeze on retail spending, which in real terms fell quite sharply around the turn of the year.
While it’s hit the income of households, however, the depreciation has come as a boon for many exporters. In sterling terms goods export prices rose 12% through the course of last year. This will significantly have boosted exporters’ profitability and with it the incentive to invest in extra capacity.
In general, it’s not really right – not enough at least – to think about the impact of a change in the exchange rate in isolation. Asset prices are volatile in the short run, sometimes inexplicably so. But over time they tend to move for a reason. They’re driven by deeper things that can have important effects of their own. To get the full picture you need to take both into account, not just the partial impact of a change in the exchange rate but those of its underlying drivers as well.
Take sterling’s fall in 2008 and 2009. One plausible explanation was that the financial sector is more important for the UK – notably its exports and the government’s tax receipts – than for other countries. So its economy and public finances were more vulnerable to the global financial crisis. The depreciation helped to cushion these effects but it wasn’t enough to outweigh them. The downturn was no less severe here than elsewhere, notwithstanding sterling’s fall.
Sterling’s more recent decline was clearly prompted by the referendum result. It also seems likely that the foreign exchange market has decided the consequences are negative. The most plausible explanation for the depreciation is that, in the eyes of the market, leaving the EU will make exporting harder and more costly. To help compensate the currency needs to be cheaper.
There are many important differences with 2008/09, of course. One is this: Brexit hasn’t happened yet. Back then sterling’s fall happened alongside its cause. On this occasion the depreciation reflects beliefs about a change in the UK’s future trading arrangements, but it’s acting on an economy where those arrangements are for the time being unchanged. The result – higher prices and profits but unchanged rules and costs – represents something of a sweet spot for exporters and businesses that compete with imports.
How they respond is one important determination of economic growth this year. Usually, one of the more positive aspects of an exchange-rate depreciation is that, by raising their profitability, it encourages the expansion of firms in the tradable sector. With the world economy in better health than for some time, there is certainty every incentive to do that today. On this occasion that response might be more muted than usual, however, because it’s not clear how long the sweet spot will last. If the currency market is right the UK’s future trading relationships will be less favourable; if it’s too pessimistic sterling is likely to rebound. Either way, future returns in the tradable sector may not be as healthy as they are right now. This may act as something of a deterrent to longer-term, sunk-cost investments in that sector.
In what follows I’ll begin by looking at sterling and what economics has to say about its reaction to the referendum result. I’ll then say something about how depreciations work in small open economies, in particular their impact on profitability and investment in the tradable sector. There’s a short concluding section.
page source http://www.bankofengland.co.uk/
