The case for UK import substitution

Opinion Sunday 23/October/2016 14:04 PM
By: Times News Service
The case for UK import substitution

The most dramatic economic effect of the United Kingdom’s Brexit vote has been the collapse of sterling. Since June, the pound has fallen by 16 per cent against a basket of currencies. Mervyn King, the previous governor of the Bank of England, hailed the lower exchange rate as a “welcome change.” Indeed, with Britain’s current-account deficit running at over 7 per cent of GDP – by far the largest since data started being collected in 1955 – depreciation could be regarded as a boon. But is it?
Economists would typically argue that the way to balance a country’s external accounts is through a fall in its currency, which would make imports more expensive and exports cheaper, causing the former to fall and the latter to rise. Higher import prices – a net loss for the country – would be offset by the higher employment and wages generated by the more competitive position of the country’s exports.
But in order for currency depreciation to work its magic, more demand for exports must be forthcoming when the exchange rate falls (or, as economists say, the price elasticity of demand for exports must be high). But various studies have shown that the price elasticity of demand for UK exports is low. For example, a recent paper by Francesco Aiello, Graziella Bonanno, and Alessia Via of the European Trade Study Group finds that “the long-run level of exports appears to be unrelated to the real exchange rate for the UK.”
This means that British consumers and producers will have to bear the entire brunt of devaluation: their import consumption will be rationed through a sharp rise in price inflation, with no offsetting gain for exports. This is by no means merely a theoretical proposition. In 2008-09, when the rest of the world was on the verge of deflation, the UK was enduring an inflationary recession, with GDP contracting at a top rate of 6.1 per cent annually, while inflation reached some 5.1 per cent. This occurred because sterling fell more than 21 per cent, peak to trough, from 2007 to 2008.
Moreover, although the current-account deficit narrowed to around 1.7 per cent of GDP in 2011, the improvement was only temporary. After 2011, the current account deficit started to widen once more, even though the pound never clawed back its losses. In economics jargon, the UK seems to be suffering from an extreme variant of the Houthakker-Magee effect – named after two economists who discovered in 1969 that price elasticities for imports and exports could diverge substantially, giving rise to a permanent tendency toward current-account imbalance.
The reason appears to be the massive contraction of the UK manufacturing sector – from around 28 per cent of gross value added in 1978 to less than 10 per cent today. As the economist Nicholas Kaldor pointed out long ago, because manufacturing has higher returns to scale than services, manufacturing exporters tend to beat service exporters.
In addition, structural reforms since the mid-1990s have ensured that British exporters are deeply integrated within global supply chains. As a result, many of Britain’s exports require imported inputs; so when sterling depreciates and import prices rise, the knock-on effect on export prices renders them less competitive. The most recent OECD data show that the import content of UK exports is around 23 per cent, compared to around 15 per cent for US and Japanese exports.
For now, the UK is relying on capital inflows into the City of London to limit sterling’s fall. But, as the exchange-rate collapse of 2008 showed, this source of foreign demand for sterling is highly unstable. When the worm inevitably turns and these flows reverse, both sterling and exports will take another hit.
The worst-case scenario would involve a sharp fall in the value of sterling, followed by sticky inflation that reinforced the rise in British export prices, fueling further currency depreciation. This doom loop would stop only when British consumers suffered a fall in real income of a magnitude not typically seen outside developing countries.
The more likely outcome is a sort of slow rotting effect, with periodic depreciations gradually driving down living standards for all who earn their living in sterling.
What is to be done? Only rapid government action to substitute goods currently imported with domestically produced goods will do the trick. The classic solution is import controls. But other measures that are less damaging to trade rules and international amity are available.
The national investment bank which the Labour Party is now advocating could be given a mandate to invest in industries with a high import substitution potential. An alternative would be to subsidize such industries directly from the Exchequer, with subsidies tied to the quality-adjusted price of the import being substituted. As the domestically produced goods became competitive with the foreign goods, the subsidies would gradually be removed and the industry allowed stand on its own two feet.
Ideally, the British government should aim to bring down imports as a percentage of GDP from the current high of around 30 per cent to pre-1974 levels of around 20 per cent. This may prove too ambitious, and the UK may have to settle for somewhere around 25 per cent of GDP. But if something is not done, Britain risks permanent impairment of prosperity. A depressed economy can be reflated, and an inflationary economy can be depressed. But losing access to crucial foreign markets as a result of currency movements outside the country’s control is largely irreversible. - Project Syndicate