In terms of trade with the EU, latest trends indicate that the UK’s deficit with EU nations has continued to widen to. Figures released by the Office for National Statistics in 2002 estimated the trade deficit as 1.7 million; this has risen significantly over the past year with figures estimated at a record deficit of 2.1 billion in November 2003. The UK’s poor trade performance with Europe is largely the result of the recent sluggishness of euro zone economies.
Although the UK’s overall trade deficit has deteriorated over the past few years, exemplified by record deficit with the EU, further widening of the trade gap has to some extent been offset by improved trade with the rest of the world, particularly the USA. Despite a widening deficit trend in 2003, figures from the Office for National Statistics showed improvements in mid 2003 driven by a bounce back in exports to non EU-countries, specifically the USA. Total exports of goods to the rest of the world rose by 7% to 15.5 billion in July-with exports to non EU countries up by 15 % compared to a rise of only 1% in EU countries. Ultimately this helped narrow the UK’s deficit with non EU counties from 2.6 billion to 1.7 billion during the second quarter of the year.
Although in 2002 Britain had a trade surplus with the USA of 538 million recent reports indicate that exports to the USA fell by 10% in the third quarter of the year. This is largely due to the strength of sterling against the US dollar which has made exports to the US less attractive. As a result the positive trend with non EU-countries noted in the second quarter of the year has not continued and as a result 2003 ended with a trade deficit of 3.3 billion.
For the UK the persistent trade deficit has a number of causes both short and long term, however the root cause of deficit is cyclical. Demand for imported goods and services rises strongly during a boom and if exports cannot match the level of imports the trade figures will become negative. Conversely in times of low economic growth the domestic economy is likely to flourish and the number of imports will fall, either reducing trade deficit or resulting in surplus. That said there are a number of underlying reasons combined with the cyclical effects, which have contributed to the UK’s current trade deficit.
Currently there is a lack of productive capacity of UK firms, which means during times of high economic growth imports are sucked into the UK in order to satisfy the excess demand. This is compounded by the fact that there is a tendency for UK consumers to consume foreign produced output; hence there is a high propensity to buy imported goods and services. In a consumer boom increased demand is likely to be reflected in the foreign market causing an acceleration in the volume of imports entering the country. The reason that UK residents are attracted to overseas goods is largely down to favourable international prices relative to UK firms and non price factors such as, quality, design, reliability, which are deemed better in certain International goods.
One of the key factors in determining the price and volume of foreign imports and ultimately the current account balance is the level of the exchange rate. Presently high interest rates in the UK compared with other EU-countries has meant that foreign currencies have been attracted into London banks. The increased foreign currency reserves have inevitably pulled up the value of the sterling. Subsequently the pound is overvalued against the euro, meaning the overseas price of UK exports has risen, while the relative price of imports has fallen. This has considerably worsened the trade deficit with the EU, producing a record figure of 2.1 billion. This has been compounded by a strong appreciation of the pound against the dollar; in December 2003 the pound had risen to unprecedented levels of $1.7361. This rise in the value of sterling has led to a rise in the foreign price of UK exported goods and services. As a result the UK has had serious difficulty in competing with overseas rivals for US and other imports. A strong exchange rate also makes imported goods cheaper inside the UK. This leads to a rise in the volume of imports and a fall in the share of the UK market taken up by goods and services from overseas.
Trading conditions for the UK have been further worsened by the effects of low cost production in newly industrialising countries. In particular this has affected the UK manufacturing industry, which is finding it hard to compete with overseas firms who are ale to produce at a lower cost. In general a declining comparative advantage, in this case the ability to exploit low cost technology means the number of exports is reduced due to the level of competition.
Although the UK is running a current account deficit and has done so for a number of years is not necessarily a sign of economic weakness. Although the current account deficit is widening it is very small in relation to the national income. Ultimately the UK economy is able to finance this by attracting inflows of capital from other economies. Britain has sustained larger current accounts of larger proportions during the late 80’s and early 90’s than what it is presently experiencing. Essentially is a prime venue for overseas investment, and as a result is able to partially finance the deficit in goods and services through the capital account. That said the problem becomes more acute if a deficit needs to be financed by loans from abroad. Governments and firms can borrow from abroad as long as they can convince foreign lenders that they can repay the loans with interest in the future. If the current account deficit is large and sustained there comes a point where foreign lenders are unwilling to continue loaning money as they believe the borrowers may default on their loans. The result is credit crunch, where foreign lenders refuse to lend any more money resulting in serious implications for the country. They are forced to return their current account to equilibrium which means cutting down on imports or exporting more goods, which reduces the amount available on the domestic market. Ultimately citizens have fewer goods available and subsequently the standard of living declines, as was the case in Poland Brazil and Uganda who all suffered credit crunch in eth late 1980’s.
Often a current account surplus is deemed more desirable than deficit because theoretically the wealth derived from the high level of exports can be used to buy more foreign goods. However large sustained surpluses are problematic like current account deficits. If a country is exporting high levels of goods and services than inevitably there is less available for domestic consumption, ultimately his may reduce the standard of living. Large sustained current account surpluses can also cause friction between countries; because if a country has a surplus this means other countries are in deficit. The country in surplus acts as a net lender, accumulating overseas wealth whilst the net borrowers build up debts. Ultimately the only way for a country to reduce their current account deficits is for the country running a surplus to reduce its exports or increase its imports. If countries are unwilling to do this, it can lead to international friction.
Presently the UK is running a current account deficit which is progressively worsening, and which is set to follow this pattern following the strengthening of the pound against the dollar and the recent sluggish performance of the euro zone economies. Government policy, although aimed at bringing about an improvement in trade performance does not necessarily seek turn a trade deficit into a surplus.
A depreciation in the exchange rate should help to boost the overseas demand for UK exports because British firms will be more competitive in the international market, supply at cheaper prices. Meanwhile a lower exchange rate should also cause imports into the UK to become relatively more expensive - leading to a slowdown in import volumes. The extent to which export sales rise and imports sales fall following a decrease in the exchange rate is dependent on the price elasticity of demand for UK products from foreign consumers and visa versa. Initially there is likely to little change in the balance of payments account as it takes time for movements in the exchange rate to affect trade flows. Despite the fact the Bank of England has devalued the pound it is still strong relative to the dollar. As a result the UK is set to lose out on trade with one of its main trading partners.
Forecasts from the Office for National Statistics indicate that despite current government policy, current account deficit is likely to worsen. It is essential that the UK controls this before too much need is placed on foreign lenders. In the long term this can be achieved by creating a sufficient productive capacity for the domestic economy and through low sustained inflation. Ultimately this will mean that the British economy is able to meet the demand for goods and it is able to deliver a sustained growth of exports. Subsequently the emphasis must be placed on supply side polices aimed at shifting out the long run aggregate supply curve. This will improve efficiency in the export sector, provide increased research and development in domestically produced goods and allow a greater focus on resources in industries where the UK has a genuine comparative advantage resulting in an improved balance of payments. Ultimately this may not be an issue if the UK adopts the single currency. If it does the UK will forfeit its control over exchange rates and interest rates, and the balance of payments will cease to be a concern, because Britain’s trade will be included with the rest of the Euro zone.