Strength of the Pound Sterling: Economy and Investment

Library Note

This House of Lords Library briefing has been prepared in advance of a debate that is scheduled to take place in the House of Lords on 17 November 2016 on the following motion:

Baroness McIntosh of Pickering to move that this House takes note of the impact on the economy and investment of fluctuations in the level of the pound sterling.

The International Monetary Fund describe the UK’s currency exchange as free-floating. Under such a system the value of a given currency is the result of a set of complex relationships between economic conditions and market forces. Consequently, the value of the pound has always fluctuated against other currencies in response to these forces. Following the result of the UK’s referendum on its membership of the EU, the value of the pound against both the US dollar and the euro fell markedly. The exchange rate of the pound against the US dollar and the euro has continued to fluctuate. A weakened pound has several implications for various aspects of the UK economy, notably imports and exports and the price of goods and services.

Daily Spot Exchange Rate between Pound Sterling and the US Dollar and the Euro, 4 November 2015 to 4 November 2016 Euro 1.7 US Dollar 1.6 1.5 1.4 1.3 1.2 1.1 1 0.9

Exchange Rate to Pound Sterling to Pound ExchangeRate 0.8

Date

Source: Bank of England, ‘Spot Exchange Rates; XUDLERS and XUDLUSS’, accessed 4 November 2016

This briefing presents information from the International Monetary Fund on different ways in which currency exchange systems can be classified. It then provides recent data on the value of the pound and commentary and analysis on the implications this has for aspects of the UK economy.

Charley Coleman 10 November 2016 LLN 2016/058

Table of Contents

1. Introduction ...... 1 2. Exchange Rates: An Introduction ...... 1 3. Pound Sterling Exchange Rates: Recent Developments ...... 2 4. Exchange Rate Changes: Impacts on the UK Economy ...... 6 4.1 Prices of Goods and Services ...... 7 4.2 Export Sales and International Trade ...... 9 4.3 Foreign Direct Investment ...... 12 4.4 Public Sector Net Debt ...... 13

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1. Introduction

Much recent commentary on the strength of the pound has been focused on the period following the UK referendum on the EU, held on 23 June 2016. Following the vote to leave the EU the value of the pound against the US dollar fell to a “30-year low”.1 This was followed by a “31-year low” a few days later.2 The International Monetary Fund (IMF) describes the UK’s currency exchange system as ‘free-floating’, meaning that the exchange rate of sterling is largely market determined.3 The UK Government has stated that it:

[…] does not have a target for the sterling exchange rate and does not comment on currency movements. Instead the exchange rate is allowed to adjust flexibly in response to economic conditions, and movements in sterling are determined by market forces.4

It argues that the UK is:

[…] going through a period of adjustment as the economy responds to the vote to leave the European Union. The fundamental strength of the UK economy means that it is well-placed to deal with the challenges and take advantage of the opportunities that lie ahead. The Government is working hard to lay the foundations for stable long term growth which will benefit savers, pensioners and all other groups.5

This House of Lords Library briefing provides data on historical exchange rates and examines some of the areas of the economy where fluctuations in the value of sterling are likely to have the greatest effect.

2. Exchange Rates: An Introduction

Exchange rates can be set in different ways. The IMF describe three main types of foreign exchange arrangements. Under each type exist several categories. Table 1 provides a summary of these as described in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (October 2015).

Table 1: International Monetary Fund Classification of Exchange Rate Arrangements

Type Categories Description Hard Pegs  Exchange Rates With In the case of exchange rates with no separate legal No Separate Legal tender, another country’s currency circulates as the Tender sole legal tender. Under a currency board  Currency Board arrangement there exists a legislative obligation to Arrangement exchange domestic currency for a specified foreign currency at a fixed exchange rate. This is combined with restrictions on the issuance authority to ensure the fulfilment of its legal obligation.

1 Bloomberg, ‘Pound Plunges to 30-Year Low as UK Stocks Slide on Brexit’, 24 June 2016. 2 BBC News, ‘Pound Slides to Fresh 31-Year Low Against the Dollar’, 5 July 2016. 3 International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, October 2015. 4 House of Lords, ‘Written Question: Sterling’, 3 November 2016, HL2646. 5 ibid.

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Soft Pegs  Conventional Peg These include a variety of arrangements by which a  Pegged Exchange Rate given country’s currency is formally pegged at a Within Horizontal given rate to another currency, or ‘basket of Bands currencies’. Outside of a ‘conventional peg’ system this can include maintaining the rate within a specific  Stabilised Arrangement percentage of the anchor currency or basket or it  Crawling Peg may involve adjusting the currency in small amounts  Crawl-like at a fixed rate or in response to changes in selected Arrangement quantitative indicators (such as past inflation differentials).

Floating Regimes  Floating A floating exchange rate is largely market (market-determined  Free Floating determined. The IMF explains that foreign exchange rates) market intervention may occur, but it serves to moderate the rate of change and prevent “undue fluctuations”. It also states that policies which target a specific level for the exchange rate are “incompatible with floating”. In free floating systems intervention occurs very rarely and the IMF only classifies as free floating if interventions are limited to no more than three instances in the preceding six months. Each intervention can last no longer than three business days.

The IMF considers that the United Kingdom has a free floating currency exchange system. The UK Government has confirmed whilst it has an inflation target it has no policy aimed at fixing exchange rates of the pound sterling and that the “value of sterling adjusts flexibly in response to economic conditions and market forces”.6

Under such a system the value of a given currency is the result of a set of complex relationships between various factors. This is one reason why currencies fluctuate, because they are dependent on the level of an array of related values and activities. For example, the Bank of England explains that a hypothetical rise in UK interest rates—relative to other countries— would provide investors with a higher rate of return on assets in the UK, relative to equivalents in foreign currencies.7 Using the Bank’s terminology, this in theory would make assets held in sterling more “attractive”. In turn, the value of sterling should therefore rise which could impact on other areas of economic activity such as exports and imports. However, the Bank also states that “the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable”.8 The IMF explain that floating currencies “may exhibit more or less exchange rate volatility, depending upon the size of the shocks affecting the economy”.9

3. Pound Sterling Exchange Rates: Recent Developments

This section of the briefing presents recent exchange rate data for the value of the pound. Three measures are presented: the ‘effective exchange rate’ of pound sterling and its spot exchange rate against the US dollar and against the euro. This briefing draws on data recorded by the Bank of England.

6 House of Lords, ‘Written Question: Sterling’, 2 November 2016, HL2598. 7 Bank of England, ‘How Does Monetary Policy Work?’, accessed 3 November 2016. 8 ibid. 9 International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, October 2015, p 72.

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The sterling effective exchange rate index (ERI) is a measure of the strength of the pound against a basket of other currencies. Countries are included in the narrow version of the index if their share of either UK imports or exports on average over the latest three-year period exceeds 1 percent. The ERI is calculated by weighting together bilateral exchange rates. The Bank of England explains that the ERI is designed to measure changes in the price competitiveness of traded goods and services, therefore the weights applied reflect trade flows in manufactured goods and services.10 The Bank provides an illustrative example using the USA, explaining that the weights for the US dollar in the sterling ERI are based on:

1. Competition in the UK domestic market from imports from the USA

2. Competition between UK exports and US products in the USA

3. Competition between UK and US exports in third country markets11

Chart 1 displays the sterling ERI from 4 November 1999 to 4 November 2016.

Chart 1: Sterling Effective Exchange Rate Index, November 1999 to November 2016 120

100

20 Sterling 2005=100) (JanSterling ERI

Date

Source: Bank of England, ‘Effective Exchange Rate Index, Sterling (Jan 2005=100)—XUDLBK67’, accessed 4 November 2016

Chart 2 displays the daily spot exchange rate between the pound sterling and the US dollar and the euro over the same time period. Spot exchange rates are “indicative middle market (mean of spot buying and selling) rates” as observed by the Bank of England’s foreign exchange desk in the London interbank market at approximately 4pm.12 The Bank explains that these are not “‘official’ rates and are no more authoritative than rates provided by any commercial bank operating in the London market. Spot rates are applicable to deals executed for settlement two working days later”.13 Please note that charts 1 and 2 use different measures of the strength of the pound and are therefore not directly comparable.

10 Bank of England, ‘Annual Reweighting of the Sterling ERI’, accessed 7 November 2016. 11 ibid. 12 Bank of England, ‘Explanatory Notes: Spot Exchange Rates’, accessed 9 November 2016. 13 ibid.

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Chart 2: Daily Spot Exchange Rate between Pound Sterling and the US Dollar and the Euro, November 1999 to November 2016 2.5 Euro US Dollar 2

1.5

0.5 Exchange Rate to Pound Sterling to Pound ExchangeRate 0

Date

Source: Bank of England, ‘Spot Exchange Rates; XUDLERS and XUDLUSS’, accessed 4 November 2016

Much recent commentary on the strength of the pound has been focused on the period following the UK referendum on the EU, held on 23 June 2016. For example, on 28 October 2016, the ONS argued that whilst the pound “has been falling for some time, the vote to leave the European Union has had a big effect in recent months”.14 Chart 3 shows the daily spot exchange rate between the pound sterling and the US dollar over the past 40 years. This shows the recent fall in the value of the pound within a longer term context.

Chart 3: Daily Spot Exchange Rate between Pound Sterling and the US Dollar, November 1976 to November 2016 3

2.5

1.5

0.5 Exchange Rate to Pound Sterling to Pound ExchangeRate 0

Date

Source: Bank of England, ‘Spot Exchange Rates; XUDLUSS’, accessed 4 November 2016

14 Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for People in the UK?’, 28 October 2016.

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Following the vote to leave the EU the value of the pound against the US dollar fell to a “30 year low”.15 This was followed by a “31 year low” a few days later.16 On 9 July 2016, the Economist argued that:

Though its value has fallen relative to the dollar, by other measures the pound is hardly cheap. The “trade-weighted” sterling index, which is adjusted for the currencies of Britain’s other trading partners, is still about 5 percent higher than it was at the peak of the financial crisis. The euro has also been knocked in the post-referendum panic, meaning that sterling’s losses against the currency of its biggest trading partner have been trimmed.17

However, since 9 July 2016 sterling ERI has continued to fluctuate. On 8 July 2016 it stood at 78.24 and on 4 November 2016 it stood at 75.60, however it had been as high as 80.16. In order to show changes in the level of the pound since the referendum in greater detail, charts 4 and 5 display data for sterling ERI and sterling exchange rate data since January 2016 only. Please note that the scales for both charts do not start at 0 in order to provide greater resolution.

Chart 4: Sterling Effective Exchange Rate Index, 4 November 2015 to 4 November 2016

100

Sterling 2005=100) (JanSterling ERI 65

Date

Source: Bank of England, ‘Effective Exchange Rate Index, Sterling (Jan 2005=100)—XUDLBK67’, accessed 4 November 2016

15 Bloomberg, ‘Pound Plunges to 30-Year Low as UK Stocks Slide on Brexit’, 24 June 2016. 16 BBC News, ‘Pound Slides to Fresh 31-Year Low Against the Dollar’, 5 July 2016. 17 Economist, ‘How Low Can It Go?’, 9 July 2016.

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Chart 5: Daily Spot Exchange Rate between Pound Sterling and the US Dollar and the Euro, 4 November 2015 to 4 November 2016 Euro 1.7 US Dollar 1.6 1.5 1.4 1.3 1.2 1.1 1

Exchange Rate to Pound Sterling to Pound ExchangeRate 0.9 0.8

Date

Source: Bank of England, ‘Spot Exchange Rates; XUDLERS and XUDLUSS’, accessed 4 November 2016

The subject of the relative strength of the pound sterling was discussed by the IMF as part of a wider ‘Selected Issues Paper’ published in February 2016.18 In this the IMF described sterling as being “moderately overvalued” by approximately 5 to 15 percent in the year 2015.19 However, the IMF also stated that its analysis was based on the assumption that the UK would remain within the EU. In a separate paper in June 2016, the IMF stated that:

An alternative scenario entailing higher trade barriers could reduce the equilibrium exchange rate (as a more competitive exchange rate would be required to raise demand for UK exports to offset the reduced demand from the EU due to higher barriers), implying that additional depreciation from 2015 levels—beyond that implied by staff’s assessment of overvalution in 2015—would be required to restore equilibrium in such a scenario.20

Commenting on the report, the organisation Full Fact wrote that:

[…] it’s hard to say whether the value of the pound has dropped lower than what the IMF would recommend. Since no-one knows what kind of trade relationships the UK will have once it leaves the EU, opinions on the UK’s long-term potential for trade or the best exchange rate for sterling are open to debate.21

4. Exchange Rate Changes: Impacts on the UK Economy

As described in section 2, the impact of sterling exchange rates on aspects of the UK economy is complex. This section draws on authoritative sources and commentary to present information on how this relationship may function. It focuses primarily on the impact of the

18 International Monetary Fund, United Kingdom: Selected Issues, February 2016. 19 ibid, pp 9–10. 20 International Monetary Fund, United Kingdom: 2016 Article IV Consultation—Press Release; and Staff Report, June 2016, p 8. 21 Full Fact, ‘Was the Pound Overvalued Before the EU Referendum?’, 17 October 2016.

House of Lords Library Note I Strength of Pound Sterling 7 exchange rate itself, rather than issues related to any hypothetical analysis of the UK’s future relationship with the remaining 27 EU member states.

The announcement on 4 August 2016 of the Bank of England’s interest rate cut of 25 basis points, to 0.25 percent (alongside a stimulus package), was aimed at meeting the monetary policy of a 2 percent inflation target.22 In its announcement, the Bank of England argued that following the result of the EU referendum:

[…] the exchange rate has fallen and the outlook for growth in the short to medium term has weakened markedly. The fall in sterling is likely to push up on Consumer Price Index (CPI) inflation in the near term, hastening its return to the 2 percent target and probably causing it to rise above the target in the latter part of the Monetary Policy Committee (MPC) forecast period, before the exchange rate effect dissipates thereafter.23

The ONS has written that this cut in interest rates “all else being equal […] could cause investors to move their money into other countries that may pay them a higher return”.24 It also pointed to “expectations from some commentators” of lower growth and higher inflation as possible reasons for the fall in the demand for sterling.25

4.1 Prices of Goods and Services

As the value of the pound decreases relative to other currencies, its buying power in foreign currencies also decreases. This will have an immediate effect on holiday makers exchanging pound sterling for currencies against which the pound has fallen.26 British people living abroad and deriving their incomes in sterling, either through wages or pensions, may also see their purchasing power decrease.27 Roger Blitz at the Financial Times also reported that the stock market has risen as “many companies in the FTSE 100 and FTSE 250 get their earnings abroad”.28

Recent press coverage has also reported on several high profile price rises, including Apple increasing the prices of its range of computers29 and negotiations between Unilever and Tesco on the price of products such as Marmite.30 The BBC has reported that “Unilever’s finance chief said such price increases are a “normal” reaction to shifts in currency values”.31 Similarly, Apple said that it:

[…] suggests product prices internationally on the basis of several factors, including currency exchange rates, local import laws, business practices, taxes, and the cost of doing business.32

22 Bank of England, ‘Bank of England Cuts Bank Rate to 0.25% and Introduces a Package of Measures Designed to Provide Additional Monetary Stimulus’, 4 August 2016. 23 ibid. 24 Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for People in the UK?’, 28 October 2016. 25 ibid. 26 Ben Chu, ‘7 Ways the Fall in the Value of the Pound Affects Us All’, Independent, 4 October 2016. 27 BBC News, ‘Brexit: Who is Affected by the Falling Pound?’, 29 June 2016. 28 Roger Blitz, ‘Who Are the Winners and Losers From the Pound’s Fall?’, Financial Times, 7 October 2016. 29 BBC News, ‘Apple Raises Computer Prices in UK’, 28 October 2016. 30 BBC News, ‘Tesco and Unilever End Price Dispute’, 13 October 2016. 31 ibid. 32 BBC News, ‘Apple Raises Computer Prices in UK’, 28 October 2016.

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However, despite this relationship being theoretically a direct one, the ONS states that:

[…] it is difficult to predict how changes in the value of the pound will feed through to the overall price level. There are many factors that could delay the effect (such as supermarkets buying stock in advance) and some businesses may choose to absorb the higher costs rather than pass them onto consumers.33

The Consumer Price Index (CPI) is a measure of inflation. The most recent data published by the ONS states that CPI rose by 1 percent in the year to September.34 The ONS explains that this was influenced by increases in the price of certain goods, but offset by falls in others:

The main upward contributors to change in the rate were rising prices for clothing, overnight hotel stays and motor fuels, and prices for gas, which were unchanged, having fallen a year ago. These upward pressures were partially offset by a fall in air fares and food prices.35

The ONS has published a bulletin alongside this that provides additional analysis of how changes in the value of sterling could have influenced CPI. It also examines the effect on the Producer Price Index (PPI)—a measure of the change in the prices of goods bought and sold by UK manufacturers.36 The ONS explains that:

Input producer prices increased by 7.2 percent in the year to September 2016, compared with a 7.8 percent increase in the year to August 2016, the third consecutive month of positive input price inflation. The recent return to positive producer price inflation can be partly attributed to the changes in the sterling exchange rate, with the effective sterling exchange rate depreciating by 14.4 percent in the year to September 2016. All else equal, a depreciation of sterling increases the prices of UK imports, with a corresponding impact on the prices paid by producers for imports. If these producers raise their prices in turn, then movements in the exchange rate can influence output producer prices.37

However, the ONS noted that inflation “has been on an upward trend since late 2015”.38 The ONS has analysed the contributions to CPI of goods and services according to their import intensity between January 2008 and September 2016. The term ‘import intensity’ refers to the percentage of final household consumption which is directly due to imports. It found that:

[…] the least import-intensive non-energy products have made a fairly steady contribution to the CPI rate of inflation between 2008 and 2016. More import-intensive products, by contrast, account for much of the rise in inflation following the depreciation of sterling in 2008 and 2009 and for much of the moderation of inflation over the last two years—a period during which sterling appreciated against its major trading partners.

33 Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for People in the UK?’, 28 October 2016. 34 Office for National Statistics, ‘UK Consumer Price Inflation: Sept 2016’, 18 October 2016. 35 ibid. 36 Office for National Statistics, ‘Additional Analysis of the Producer Price Index (PPI) and Consumer Price Index (CPI): Sept 2016’, 18 October 2016. 37 ibid. 38 Office for National Statistics, ‘UK Consumer Price Inflation: Sept 2016’, 18 October 2016.

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In September 2016, the largest contribution to consumer price inflation continued to come from goods in the lowest import intensity category (0 to 10 percent). This group of products and services still dominates the slight upward contribution seen for the most import intensive goods and services (40 percent plus), and the contributions for each category increased by comparable amounts in September.

Energy has seen a fall in its negative contribution to the CPI in September 2016. This can mainly be attributed to price falls between August and September last year, although it is possible that it could be influenced by the stabilising of commodity prices being offset by the depreciation of sterling.39

The Head of Inflation at the ONS, Mike Prestwood, stated that September’s inflation figures suggest “there is no explicit evidence the lower pound is pushing up the prices of everyday consumer goods”.40

4.2 Export Sales and International Trade

As a fall in the value of the pound relative to other currencies may be expected to increase the price of imports, it may also be expected to make UK exports cheaper and more price competitive. As a consequence, more money may flow into the UK economy through increased exports. As with price rises for imported goods, there are many practical considerations as to why this relationship may not purely be a direct one.

The ONS argues that factors influencing this relationship include:

 How well UK companies are set up to exploit export markets—for example, it can take time for a business to adapt its processes to sell overseas and find profitable opportunities where potential customers will demand its goods.

 The economic conditions in other countries—if other countries are in an economic downturn they will not have the money to spend on our goods.

 How sensitive the demand for our exports is to price—for example we export Rolls Royce cars but the demand for these is not very sensitive to price changes as they are a luxury item. This means the number sold may not significantly change as the price changes.

 The trade arrangements that exist to access markets across the world.41

Writing on the Centre for Economic Policy Research’s policy blog in October 2015, researchers from the IMF wrote that some have argued that exchange rates have a reduced impact on trade compared to the past:

Exchange rate movements have been unusually large and have sparked some controversy as to their likely effect on exports and imports. Some suggest that exchange rates matter far less than they used to, and may have disconnected from trade entirely.

39 Office for National Statistics, ‘Additional Analysis of the Producer Price Index (PPI) and Consumer Price Index (CPI): Sept 2016’, 18 October 2016. 40 Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for People in the UK?’, 28 October 2016. 41 ibid.

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Claims like these are not at all new—they have been around at least since the economist Fritz Machlup coined the phrase ‘elasticity pessimism’ back in 1950.42

The authors state that this argument is often based on the assertion that the production of goods has become “fragmented across countries in global value chains”.43 They point to the example of smartphones assembled in China from parts manufactured in multiple countries, and observe that:

A rising share of exports consists of components imported from abroad (foreign value content), and a currency depreciation should thus provide a more limited boost to exports. The puzzling weakness of Japanese exports since 2012 despite the yen’s depreciation of more than 30 percent in real effective terms has further fuelled the disconnect debate.44

Based on their own analysis, the authors argue against this point.45 Looking at data on 50 advanced and emerging market and developing economies over the last 30 years they assert that there is a “strong link between exchange rates and trade”, stating that “overall, we estimate that 10 percent real effective exchange rate depreciation implies, on average, a 1.5 percent of GDP increase in real net exports”.46 However, they also state that there is substantial cross-country variation around this average.47 They also that:

[…] these effects fully materialize over a number of years, [but] much of the adjustment occurs in the first year. The boost to exports associated with currency depreciation is found to be largest in countries with initial economic slack and with domestic financial systems that are operating normally. Some evidence suggests that the rise of global value chains has weakened the relationship between exchange rates and trade in intermediate products used as inputs into other economies’ exports. However, the bulk of global trade still consists of conventional trade, and there is little evidence of a general trend toward disconnect between exchange rates and total exports and imports.48

Between Q3 2007 and Q1 2009 the sterling effective exchange rate depreciated by 25 percent following the “economic downturn”.49 In August 2013, the ONS examined what effect this fall had on the UK’s balance of trade in subsequent years. Writing at the time, the ONS stated that “despite a brief increase between Q2 2007 and Q4 2008, the trade balance has remained around its pre-depreciation level and shows little clear evidence of the depreciation”.50 The ONS argued that whilst the performance of exports relative to imports did improve following the depreciation, given the “magnitude” of the fall in sterling “a stronger response might have been expected from exports in particular”.51

42 Daniel Leigh et al, ‘Exchange Rates Still Matter for Trade’, Centre for Economic Policy Research Policy Blog, 30 October 2015. 43 ibid. 44 ibid. 45 International Monetary Fund, World Economic Outlook—Chapter 3: Exchange Rates and Trade Flows: Disconnected?, October 2015, pp 105–42. 46 ibid. 47 ibid, p 105. 48 ibid. 49 Office for National Statistics, Explanation Beyond Exchange Rates: Trends in UK Trade Since 2007, 22 August 2013. 50 ibid, p 4. 51 ibid, p 5.

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The ONS concluded that the following factors may explain this response:

 The UK has become more deeply integrated into the global economy, and the increasingly global nature of supply chains.52

 An increasingly large percentage of the UK’s exports came from services; between 1998 and 2007 the proportion increased from 30.2 percent to approximately 42.2 percent of all exports. The ONS argued that this made UK exports particularly vulnerable to the downturn in the world economy in 2007.53

 The fact that firms may or may not pass on the full cost, or benefit, of an exchange rate change to customers. The ONS stated that:

[…] the depreciation appears to have had the predicted effect on sterling import prices, which increased by 21 percent between Q4 2007 and Q4 2012. The depreciation also had the predicted impact on the effective price of UK exports, which fell sharply during Q4 2008 and Q1 2009, supporting the recovery in trade during 2009 and 2010. However, effective export prices have since risen above their pre-depreciation level, which may offer a partial explanation for the recent weakness of trade.54

 The ONS also highlighted the role of commodities, particularly oil, describing modern economies as having a relatively “price inelastic demand for oil”.55 The ONS wrote that the “rise in the dollar price of oil, the depreciation of sterling and the relatively inelastic demand for oil have had a substantial impact on the UK’s trade position”.56

 Annual CPI inflation was consistently higher in the UK than other G7 countries. The ONS explained that:

If prices in one economy rise more rapidly than those in other economies with no change in the exchange rate, the balance of trade is likely to change. Higher domestic prices make domestic goods relatively more expensive in overseas markets. This reduces demand for domestic exports. Higher domestic prices also make imported goods relatively more attractive for domestic firms and consumers. As a result, consistent, relatively high rates of inflation tend to reduce the trade balance through lower exports and higher imports.57

 The ONS argued that many of the UK’s trading partners had suffered “contractions in output, increases in unemployment and correspondingly limited demand growth”.58 The ONS suggested that this may have limited the impact of the change in the exchange rate due to decreasing demand for UK products overseas.

52 Office for National Statistics, Explanation Beyond Exchange Rates: Trends in UK Trade Since 2007, 22 August 2013, p 8. 53 ibid, p 10. 54 ibid, p 16. 55 ibid, p 16. 56 ibid, p 18. 57 ibid, p 19. 58 ibid, p 21.

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In October 2016, the ONS stated that it has “limited data on how exports have performed following the [recent] fall in the pound”.59

4.3 Foreign Direct Investment

The United Nations Conference on Trade and Development (UNCTAD) defines foreign direct investment (FDI) as an investment which is made to:

[…] acquire lasting interest in enterprises operating outside of the economy of the investor. Further, in cases of FDI, the investor’s purpose is to gain an effective voice in the management of the enterprise. The foreign entity or group of associated entities that makes the investment is termed the “direct investor”. The unincorporated or incorporated enterprise—a branch or subsidiary, respectively, in which direct investment is made—is referred to as a “direct investment enterprise”.60

UNCTAD states that some degree of equity ownership is normally considered as necessary to be considered to have an effective voice in the management of an enterprise. Generally, this is considered to be 10 percent of equity ownership.61

The ONS has produced a short briefing on the impact of the recent changes in the value of sterling on FDI. UK investments in overseas companies are referred to as FDI assets. Overseas investors’ investments in the UK are known as FDI liabilities. It explains that “as with many cross-border economic statistics”, UK FDI values fluctuate in response to changes in currency exchange rates.62 FDI assets are more likely to be denominated in foreign currency as compared with overseas investments in the UK, according to the ONS. Therefore, it argues that UK FDI assets should experience larger revaluations in response to fluctuations in sterling. The ONS stated that:

As asset and liability values are measured at the period end, the depreciation in sterling in the final few days of Quarter 2 2016 will have impacted on the UK’s international investment position for Quarter 2 2016. In contrast, the impact on earnings is likely to be less immediate, as only earnings in the final seven days of the quarter are affected; although, should the sterling exchange rate remain at current levels, earnings in future quarters will be affected, all else being equal.63

Foreign Investment in UK Assets

Following the depreciation in the pound there have been press reports that purchase of UK assets may become more attractive as foreign currencies strengthen against sterling.

59 Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for People in the UK?’, 28 October 2016. 60 United Nations Conference on Trade and Development, ‘Foreign Direct Investment (FDI)’, accessed 8 November 2016. 61 ibid. 62 Office for National Statistics, ‘The Impact of Recent Currency Fluctuations on Foreign Direct Investment (FDI) Statistics: Quarter 2 (Apr to June) 2016’, 30 September 2016. 63 ibid.

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On 6 July 2016, an article in the Telegraph said that:

Investment managers have reported an increase in enquiries from overseas money wanting to buy sterling-linked assets, particularly commercial property, with the current exchange rate meaning they will get a better deal.64

However, it went on to say that according to those “working in the sector” investors are “concerned” about the “wider volatility in the UK since the result of the European Union referendum and are likely to sit on capital until some of the political and economic uncertainty is resolved”.65 Writing about the purchase of the British technology firm ARM Holdings by the Japanese company Softbank, the BBC’s Business Editor, Simon Jack, wrote that the desirability of ARM had been

[…] boosted by the fall in the value of the pound since Brexit—making UK targets cheaper and many industry watchers are predicting a new wave of foreign takeovers.66

The BBC also quoted Dan Ridsdale, an analyst at Edison Investment Research, as saying that:

An increase in inbound merger and acquisition activity was one of the obvious consequences of Brexit and weakened sterling, but few expected it to manifest itself so quickly or at so large a scale.67

However, the Wall Street Journal reported that:

Despite the recent drop in the value of the British pound after [the UK’s] decision to exit the EU, Mr Son [Softbank’s Chief Executive] said that didn’t affect his decision. The deal doesn’t actually bring a so-called Brexit discount, because ARM’s shares have traded higher over the past month, more than offsetting the drop in the pound since the Brexit vote.68

4.4 Public Sector Net Debt

Fluctuations in the value of sterling may also be expected to have an effect on public sector finance. On 14 July 2016, the ONS published a short briefing stating the recent large movements in the value of sterling “highlighted a need for clarity on the impact of these exchange rate movements on the Public Sector Net Debt (PSND)”.69 The ONS explained that:

Public Sector Net Debt (PSND) is net of liquid assets and more than half of these liquid assets are held as foreign currency assets in the Official Reserves. Recent falls in the price of sterling will have led to an increase in the sterling value of these foreign currency assets and so, all other things being equal, a fall in PSND. However, around two thirds of the foreign currency assets in the Official Reserves are ‘hedged’ against exchange rate movements largely through the use of currency swaps. The swaps effectively fix the sterling value of these assets. Where this hedging is in place the value

64 Rhiannon Bury, ‘Opportunistic Foreign Investors May Swoop on UK Assets as Pound Slumps’, Telegraph, 6 July 2016 65 ibid. 66 BBC News, ‘ARM Chip Designer to be Bought by Japan's Softbank’, 18 July 2016. 67 ibid. 68 Stu Woo, Rick Carew and Eva Dou, ‘SoftBank to Buy ARM Holdings for $32 Billion’, Wall Street Journal, 18 July 2016. 69 Office for National Statistics, ‘Impact of Foreign Exchange Rate Movements on Public Sector Net Debt’, 14 July 2016.

14 House of Lords Library Note I Strength of Pound Sterling

of the assets as recorded in debt will not vary with the latest exchange rates but will reflect the ‘fixed’ sterling value. This means that the reduction in PSND will be less than might be expected based on the movement in exchange rates.70

The ONS announced a methodological change for the June 2016 Public Sector Finances Bulletin, the effect of which:

[…] introduces a change to the PSND methodology in relation to the valuation of foreign currency denominated liquid assets which are “hedged” against exchange rate and price movements. In recent periods the value of these assets changed with movements in foreign currency exchange rates but the new methodology guidance states that the assets are to be valued at the sterling value ‘fixed’ through the hedging instrument.71

This followed a recommendation of the Public Sector Finances Technical Advisory Group (PSFTAG).72

70 Office for National Statistics, ‘Impact of Foreign Exchange Rate Movements on Public Sector Net Debt’, 14 July 2016. 71 Office for National Statistics, ‘Public Sector Finances: June 2016’, 21 July 2016. 72 Office for National Statistics, ‘Impact of Foreign Exchange Rate Movements on Public Sector Net Debt’, 14 July 2016.

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