## Friday, 12 July 2013

### UK Trade Elasticities

Between 2007 and 2009, the UK saw a 20% fall in its real exchange rate.  Whilst this was not enough to put the trade balance into surplus, it does appear to have achieved some reduction in the large deficits which have persisted since 1998.

The graph below shows the trade balance as a percentage of GDP and the real effective exchange rate.

What I wanted to do was to break down the trade balance into price and quantity measures for both exports and imports, to see where the apparent effect was coming from.  No doubt, someone has down this before somewhere, but it's the sort of thing I find useful to explore myself.

Before having a look at this, it is worth considering the Marshal-Lerner condition.  The idea behind this condition is a fall in the exchange rate will cause export volumes to rise and import volumes to fall.  However, any such devaluation will also raise the domestic equivalent price of imported goods.  The Marshal Lerner condition therefore says that combined price elasticities of exports and imports needs to exceed one in order to overcome the rise in price of imports, if a devaluation is to improve the trade balance.

The purpose of this exercise is to look at what this means in practice.

We can write the percentage trade balance as:

B  =  ( X - M ) / Y

where B, X, M and Y are the balance of trade as a percentage of GDP, exports, imports and GDP, all in nominal terms.

We can rewrite this as:

B  =  x . w . px  -  m . pm

where:

x is real exports divided by the real volume of world trade

w is the real volume of world trade divided by real GDP

px is the export deflator divided by the GDP deflator

m is real imports divided by real GDP

pm is the import deflator divided by the GDP deflator

The first thing we want to do is to remove the effect of changes in w, because this is unlikely to be significantly dependent upon the exchange rate.  This is done by calculating a trend value for each of real world trade and real GDP and adjusting exports accordingly.  This gives an adjusted trade balance as shown below.

This is basically what the trade balance would have been if both world trade and GDP had been equal to their trend values (assuming the other parameters are independent).

We can now break down the impact on the trade balance by looking at how each of x, m, px and pm changed over the relevant period.  These are shown in the graphs below, firstly for px and pm, and secondly for x and m.

One of the most interesting things about these graphs is how closely the price deflators for imports and exports move together.  Both appear to adjust in response to the exchange rate movement, with the import deflator moving only slightly more.  This contrasts with the theory behind the Marshal Lerner condition, which assumes that only import prices will change and that they will change one for one.

In fact what we see is significant price adjustment in both exports and imports to take account of the revaluation.  Overseas vendors reduce their foreign currency prices to stay competitive within the UK market and UK exporters increase their prices to take advantage of the lower exchange rate.  This partly reflects an element of re-export within UK trade, but it also suggest a high degree of pricing flexibility for exporters and importers.

We can next look at the response of export and import volumes (ignore the spike in both exports and imports in 2006, which relates to MTIC fraud).  First of all, we notice that there is very little change in export volume.  There is perhaps a slight increase after the devaluation, but not much.  The effect on imports is more noticeable.  The sharp fall in sterling checks a steady upward trend and actually causes a significant, but temporary fall in the import ratio.  This dip in import propensity is the main cause of the spike we see in the adjusted trade balance graph.

One interesting point here is that the UK appears to fail the Marshal Lerner condition.  My own estimates for the long-term price elasticities of exports and imports are -0.1 and -0.6 respectively.  If prices changed as assumed by Marshal-Lerner, then a devaluation of sterling would lead to a worsening of the trade balance.  However, the close correlation of price movements in both imports and exports means that the volume improvements do in fact improve the balance of trade.

Nevertheless, the other notable thing about these graphs is the strong upward trend in the UK's import ratio.  The decline in the exchange rate halts this for a while, but we can see that it is then starting to resume its upward course.  The growing propensity to import remains one of the UK's greatest long-term constraints.

Data used
IKBH,IKBI,YBHA,IKBK,IKBL,ABMI - source ONS
World trade volume deflated by US HICP - source OECD
Real effective exchange rate - source BIS

#### 4 comments:

1. I have wondered if a version of Gresham's law applies internationally. The international version would stipulate that a weak currency will attract workers from the strong currency economy.

A strong currency economy tends to have higher unemployment. An unemployed person would work for a weak currency rather than have no job.

For this to happen, the worker in strong currency country would need currency exchange assistance.

2. I'm not sure. You might see some cases, where workers insist on being paid in a hard currency, but I think we're some way from a position where the reverse might happen.

I think the more important question is what does this mean in terms of real wage bargaining in the domestic currency.

3. I guess importers and exporters hedge against currency movements by using financial derivatives. So an importer will sell goods in the UK at the price that UK consumers can afford even though that means selling at less than the cost of production. The gain that the importer has got from the currency hedge prevents an overall loss being suffered. Likewise exporters need to keep the selling prices of exported goods high so as to cover losses incurred on exchange rate hedges moving against them.
Perhaps that just creates a delay of a few years leaving the underlying dynamic in place. It might create unfortunate feedback oscillations as price signals get obscured. The hedging cost is also a constant drag on the real economy too I guess.

4. That's an excellent point.

I think that hedging of costs tends to be more widespread than hedging of revenues, but the latter definitely goes on as well.

I can see that this deserves a bit of thought. It may be yet another area where growth of derivatives makes it harder to interpret the data.