What are the mechanisms by which a weakening world economy would impact on the UK market? In this context, how does the declining exchange rate of the pound against the Euro contribute to the future prospects of the UK economy?

Executive summary

The weakening world economy impacts on the UK market through a combination of inflation rates, import and export volume, and credit markets. As the pound declines against the Euro, exports become more competitive, hence boosting the profits of exporting companies, but imports become more expensive, hence reducing the amount of goods consumers can purchase.

Introduction

The current financial crisis originated in poor quality mortgage lending practices by US banks, who were willing to extent loans to borrowers unable to repay them as these loans could be sold as bonds to make profits for the bank (Hutton, 2008). The risks from these mortgages, and hence the losses from defaults, have been spread across the global economy through the bond markets. As such, the world economy is now weakening. This piece will examine the mechanisms by which this weakening impacts on the UK economy, and how the declining exchange rate of the pound is contributing to this impact.

Main body of the work

Last year, in the midst of rising UK inflation rates, one of the members of the Monetary Policy Committee of the Bank of England stated that the world economy is one of the most significant influences on the inflation rate in the UK. This is because of the global markets which exist for commodities such as corn, wheat, iron, aluminium and oil, as well as for manufactured goods. As such, as the world economy weakens, so the demand for these commodities falls and hence so does their price. This can lead to falls in the rate of inflation in the UK, which is now a net importer of many commodities including food and oil (Bank of England, 2007). Indeed, the open and global nature of the UK economy means that global economic factors "can cause inflation to fluctuate around its target level in the short term, and also inject volatility into the real economy" (Bank of England, 2007). This implies that a weakening world economy will tend to increase the volatility of inflation rates in the UK, hence affecting the overall economy.

In addition, the US Department of State (2008) reports that the UK directly exports $415.6 billion or goods each year, and directly imports $595.6 billion, from its $2.15 trillion total economy. However, Brittan (2003) reports that the sales made by UK affiliates in foreign companies are around five times the volume of the direct UK exports. This implies that the UK economy is strongly dependent on the world economy, both for direct exports and the additional cash inflows from the affiliates. Whilst the affiliates and other overseas owned subsidiaries do not have a direct impact on the UK economy, any fall in sales for them will reduce corporate earnings, hence reducing government tax revenues and investor returns. As such, as the world economy weakens global consumption will tend to fall. The main mechanism by which this will be transmitted to the UK will be in the form of reduced profits and tax revenues, thus putting pressure on companies to make efficiency savings, and making it harder for the government to balance the budget (Brittan, 2003). In the long term, this implies higher levels of unemployment and higher taxes or lower government spending in the future.

Finally, it is not only the UK's inflation rate and corporate profits which are affected by the global economy, but the credit markets as well. Hutton (2008) argues that the current slump has been caused by falling US property prices, which have hurt the returns on residential mortgage backed bonds and caused large losses to businesses which invested in them. These bonds were sold on to investors around the world, hence the world economy is now suffering from a lack of credit and an unwillingness of banks to lend. This affects the UK economy through two mechanisms. Firstly, UK banks have lost significant amounts of money, and are unwilling to lend to businesses, who thus find it harder to invest in growing their business, and consumers, who thus find it harder to make purchases on credit, and must focus on paying back their expensive existing debts. In addition, many UK businesses depend on the global credit markets for financing and refinancing, either directly or indirectly. As such, the current lack of liquidity is pushing up their cost of capital, and hence making businesses less attractive for investors.

Within this context, as discussed the UK has a significant dependence of trade with the EU, with the US Department of State (2008) stating that the EU is one of the UK's major import and export markets. Therefore, as the GBP / EUR rate declines, the UK's exports become cheaper in the Eurozone, where they are prices in Euros. This makes it easier for UK businesses to sell products in the Eurozone, as they will become cheaper relative to products manufactured by incumbents in the Eurozone markets. In addition, any profits made by UK owned subsidiaries or affiliates in the Eurozone will be in Euros, and hence will be higher in value when they are repatriated to the UK and potentially taxed. However, conversely imported goods from the Eurozone will become more expensive. This will lead to higher levels of inflation, potentially reducing the amount of money which UK consumers have to spend, if they depend on vital goods from the Eurozone, such as food. Therefore, the declining exchange rates will hurt consumer spending in the UK economy, but potentially boost the profits from exports and investments in the Eurozone. Ultimately, this will help UK businesses recover some of their profits, but consumers will have reduced purchasing power for the near future.

Conclusion

As the world economy weakens, the global demand for goods falls. This leads to short term falls in price for commodities and some manufactured goods, hence reducing the UK inflation rate. However, the reduced demand also reduces the profits UK companies will make from exports and foreign investment. In addition, the losses on bonds have made banks unwilling to lend, hence reducing the amount UK businesses have to invest, and consumers have to spend. As the pound depreciates against the Euro, the UK economy will become more competitive, as its goods will be cheaper relative to those priced in Euros. However, this will mean that UK consumers will have to pay more for goods produced in the Eurozone.

References list

  1. Bank of England (2007) News Release: Speech by Andrew Sentance - The Global Economy and UK Inflation. 24th September 2007 http://www.bankofengland.co.uk/publications/news/2007/098.htm Accessed 22nd November 2008.
  2. Brittan, S. (2003) The UK economy in a world context. 29th October 2003. http://www.samuelbrittan.co.uk/spee30_p.html Accessed 23rd November 2008.
  3. Hutton, W. (2008) A deluded Wall Street threatens the world economy.16th March 2008. http://www.guardian.co.uk/commentisfree/2008/mar/16/creditcrunch.useconomy Accessed 23rd November 2008.
  4. Sloman, J. (2006) Economics: 6th Edition. Financial Times / Prentice Hall.
  5. US Department of State (2008) Background Note: United Kingdom. July 2008. http://www.state.gov/r/pa/ei/bgn/3846.htm Accessed 22nd November 2008.