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Economics Weekly - Will the fall in the UK’s exchange rate boost manufacturing? Weekly economic data preview - BoE MPC minutes and UK Q1 gdp in focus

Economics Weekly 21 April 2008

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

Despite all the gloom, UK manufacturing outputis 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 from4.8% 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.
Trevor Williams, Chief Economist, LTSB Products and Markets

Weekly economic data preview W/c 21 April 2008

BoE MPC minutes and UK Q1 gdp in focus
An important week lies ahead for the
UK where preliminary Q1 gdp data will provide an update on the state of the whole economy. The MPC minutes will reveal whether the BoE was unanimous in its vote to lower Bank rate to 5.0% two weeks ago. Separately, the BoE may announce new measures as it tries to clear the gridlock in money markets by offering gilts in exchange for mortgage backed securities. Home sales will be the principal subject of scrutiny in the US and members of the Fed may share some final thoughts before they meet on interest rates on 29/30th April. The IFO business confidence survey and CPI inflation data are due from Germany and may show resilient confidence and high inflation. We expect interest rates to be cut in Canada, but forecast no policy changes in Sweden, New Zealand, and Norway (risk of a rate rise).

• The MPC minutes are due on Wednesday and may give some idea of the most likely trajectory for UK base rates in the months ahead. Two questions stand out: was the MPC unanimous in its vote to cut rates to 5.0% two weeks ago, and to what extent do the committee members believe that the stress in the money markets will affect its quarterly inflation and growth forecasts? Since the Bank cut rates earlier this month, 3 month Libor has hardly budged. It closed last Friday at 5.89%, barely 3bp below 5.92% on April 10th. The resulting widening in the spread over base rate to 90bp means that credit conditions have actually deteriorated. Whether the credit market turmoil has adversely affected the economy in the first quarter of 2008 should become clearer on Friday when the preliminary Q1 gdp data will be published. Data for retail sales, industrial output and the services PMI suggest that activity may have held up close to trend growth, i.e. 0.6% q/q. Our forecast is 0.5% and this would mean a drop in the annual growth rate to 2.6% from 2.8% in Q4 2007. Where the start of the second quarter is concerned, participants will concentrate on the retail sales data for April due on Thursday. Weak anecdotal evidence from the British Retail Consortium suggest that retail sales may have dropped by the most since January 2007 when sales fell by 1.6%. This would probably give a more up-to-date reflection of how the economy is shaping up in the face of tight credit conditions, falling house prices and stagnant real wage growth. The latest CBI industrial trends survey is also due on Thursday and is forecast to show a steady backdrop for industrial activity in April compared to March. There is a good chance that the decline in sterling, especially vs the euro, may have buoyed confidence among exporters.

• The next Fed FOMC meeting is just one week away and discussions about the likelihood of a rate cut are likely to overshadow events in the US this week. Interest rate futures suggest the Fed may not lower interest rates on April 30th after the Beige Book last week warned of inflation, and good Q1 earnings from a majority of US companies. Economic data releases include existing and new home sales for February and durable goods orders for March. Weak housing starts and building permits data last week demonstrated that high levels of housing stock are still weighing on residential construction. To what extent lower house prices are stimulating demand for existing and new dwellings and how fast inventories are being worked off is crucial to understand where construction and related sectors are headed in the next few months. Durable goods orders have been very weak so far in Q1 and this does not augur well for the contribution of business investment to gdp. The deterioration in credit markets in March has tempered the likelihood of a rebound in new orders from the sharp declines in January and February.

• The worsening backdrop for euro zone inflation - CPI rose in March to 3.6% - led the ECB last week to reiterate its concern that inflation expectations could be dislodged. How the euro zone economy is evolving in Q2, and what this may mean for prices, will be clearer in the manufacturing and services PMI surveys on Wednesday. The German IFO survey is on Thursday forecast to show a resilient backdrop for manufacturing. German inflation data may show that price pressures stayed elevated in April.
Kenneth Broux, Economist

Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500

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