case

BUSMGT 714 Economics for Managers

TBL CASE

WEEK 8

A High Exchange Rate

Is it necessarily bad news for exporters in the long term?

Usually, a higher exchange rate hurts the export sector of economics due to less competitive price of exported goods in the international market. However, during atime period in a previous decade, the French government operated a policy designed to keep the franc strong. Even though employment suffered as French exporters found it difficult to compete in foreign markets, its long-term consequences proved more beneficial for many French industries. To remain competitive overseas, many French producers were forced to reorganise production, cut costs, and modernise in a drive to improve efficiency. Today many sectors of French industry are amongst the most productive in the global economy.

Understanding the history and causes of exchange rate values can help us understand reasons behind current relative exchange rates better. During the early 1990s the Japanese, like the French, experienced a similar rise in the value of the yen. It rose by over 24 per cent against the dollar and by over 43 per cent against the German mark in 1993 alone. Japanese business responded by relocating more of its production overseas, and relying less on export sales. The cost to the Japanese economy was slower growth and unemployment in some periods, something the Japanese economy had seldom experienced in recent times. In the long term, however, Japanese business has benefited from extending its global operations. In the late 1990s, the Japanese economy was in a depressed state, and was unlikely to pull free from this until the south-east Asian economy recovered from its collapse in 1997. But the global spread of Japanese business helped it to spread risk and cushion the loss in profits from the depressed domestic and regional economy.

Figure 1 below shows the pound sterling exchange rate, i.e. a trade-weighted index of sterling against a basket of currencies. It shows clearly the rise in sterling in 1997 and the persistence of a higher exchange rate through to 2008. So, should British exporters have been so worried by the high value of sterling from 1997? Might there not be some advantages in the long term?

UK industry, unlike that in France, went through severe recessions in the early 1980s and early 1990s. On both occasions, UK managers were forced to cut costs as prices were driven down. Whether UK industry can make further substantial efficiency gains to maintain its export competitiveness remains to be seen.

From December 1995 to April 2000 the sterling index rose by 29 per cent, and many exporting industries were finding it dificult (see Figure 1 below). Take the case of Corus (formerly British Steel). The rise in sterling has reduced Corus’s profits by over £1 billion per year. As a result, the company has undertaken major restructuring and plant closures and has cut jobs by over 13,000.

Source: Based on data in Monthly Review of External Statistics (National Statistics)

Figure 1 (Pound) sterling exchange rate from 1980 -

Foreign producers in the UK market, such as Nissan, were also concerned about the effects of the rise in sterling. In 1998 a representative of Nissan made the following statement:

We have been somewhat taken aback by the speed and extent of sterling’s dramatic rise on the foreign exchanges. We export about 75 per cent of our production from Britain which makes it inevitable that our profits are being reduced. We cannot manipulate our retail prices in export markets, because those prices are determined by market leaders.

From 2003 through until 2007, the pound remained strong (see Figure 1). The pound peaked in July 2007. Against the US dollar it peaked at £1 = $2.0338 while against the euro it reached £1 = €1.4821. So why was the pound so strong on world markets?

· Speculators were attracted by the high value of UK interest rates being used by the Bank of England to dampen domestic inflationary pressures. Even when the interest rate began to fall in 2001, it remained high relative to rates in the eurozone and Japan and, increasingly, relative to rates in the USA. Evidence suggests that sterling is the most interest rate sensitive of major currencies.

· The UK was perceived by foreign investors as a safe haven from the uncertainties of European economic and monetary union, the 1997/8 currency crisis in south-east Asia, the unsure Japanese economy and, in the early 2000s, the slowing US economy. More recently the pound’s strength has increasingly encouraged overseas central banks to hold sterling as part of their reserves. For example, the share of sterling in Italy’s foreign exchange reserves went from 0 per cent in 2004 to 24 per cent in 2005.

Export Strategies:

One strategy UK exporters might have adopted when faced with a high value of sterling, was to look very carefully at all the various export destinations in which they might sell their products or services. The reason for doing this is that sterling was unlikely to strengthen by the same amount against all currencies. The following table illustrates how the rise in sterling differed between nations. A large proportion of the UK’s export trade goes to other EU countries and most have adopted the euro.

Sterling’s depreciation and then appreciation since 2008

From mid-2008, however, the rate of sterling against the euro fell significantly. This was caused by larger interest rate reductions in the UK than in the eurozone, worries about the state of the UK economy and the unwinding of the carry trade.

But was a lower exchange rate good news for UK exporters? In the short run it certainly was, as foreign exchange earnings were worth more in terms of sterling. It also gave exporters greater scope for reducing prices in foreign currencies in order to compete more effectively with foreign companies. It also gave a boost to domestic industries competing with higher-priced imports. For example, people might prefer to holiday at home rather than abroad, given that foreign currency was costing more.

2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: Based on data in Trade in Goods MRETS (National Statistics), Table G1.

Figure 2 Depreciating then appreciating sterling in the past decade

Whether the fall in sterling would have a beneficial effect on inward investment, however, depends on whether people believed that the exchange rate would remain low. One of the problems here is the uncertainty generated by considerable fluctuations in exchange rates. Just as sterling fell both rapidly and substantially, it might well rise again relatively rapidly, for example if inflation started to rise faster than in other countries, forcing the Bank of England to raise interest rates, thereby encouraging an inflow of short-term liquidity.

Indeed, this is just what happened from 2013, when it became apparent that the UK economy was beginning to recover more quickly that eurozone economies. It was increasingly likely that the Bank of England would raise interest rates before the European Central Bank. Consequently, the exchange rate began to appreciate again (see Figure 2 above). From July 2013 to August 2015, the sterling exchange rate index rose by over 17 per cent.

In other words, it is not just the level of the exchange rate that affects inward investment, but also how stable it is and the direction in which potential investors expect it to move.

This case focuses on UK’s experience with a rising Sterling exchange rate and it provides many useful learning opportunities. Indeed, the exchange rate experiences of many countries provide valuable learning cases. This is true of both cases pointing to best possible economic strategies, when a currency has appreciated, or in some countries depreciated, over sustained time periods.

Question 1. This case study focuses on the UK and movements of Pound Sterling. Research with your team, and find the example of another European or Asian country that has also experienced sustained appreciation of their currency over a time period. Support your choice with information. (a) What were the main causes for the appreciation of your selected country’s currency? (b) Did the appreciation of the currency result in economic consequences that were similar to, or different from the UK case? Explain why. 2. What have you learned about best strategies for economic success when a currency appreciates, based on the combination of the UK case study, and the currency case you selected in Q1? 3. Research with your team and draw a graph that continues the exchange rate copmparisons of Figure 2, from 2016 to 2021. (a) How has the Pound Sterling value changed against these currencies since 2016? Has it kept its strong currency position? Is there any indication that the Covid Pandemic (e.g. less travel to the UK) or Brexit have weakened the sterling? Discuss why or why not. 4. (a) Identify whether a stronger or weaker exchange rate policy (against the Chinese Yuan) is suitable for New Zealand exporters? Explain in economic terms and referring to the NZ economy specifically, why or why not. Question 4 (b) will be provided at the TBL session.

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