Webcast 035 | UK Economic prospects for the next five years

Ahead of the Queen’s speech, Delta’s CEO Rebecca Harding talks to Frances Coppola and Shaun Richards about the UK’s economic priorities for the next parliament.


Webcast 035 Author  |  Rebecca Harding  |  CEO

Guest Blog | Services trade should be a UK strategic priority

The release of UK balance of payments current account figures for 2014 was greeted by the usual shock horror headlines. The deficit in 2014 was close to £100bn, and reached the highest share of GDP recorded since 1948. Our current account deficit of 5.5% of GDP in 2014 exceeded the previous peaks of 4.4% in 1989 and 3.9% in 1974, after the first OPEC oil price shock.

These headline figures were a bit misleading, however. The underlying trade position for the UK has not deteriorated – for 2014 as a whole the deficit in goods and services was less than 2% of GDP and the figures were on an improving trend through the year. The current account figures reflect some unusually large net outflows of income which could turn out to be a temporary phase.

Digging down further into the trade figures we can find more good news. In 2014, the UK’s exports of services hit a new record – nearly £215bn. The value of UK exports of services is now very close to the total value of our manufactured exports (£225bn). In addition, we run a large trade surplus on services – totalling nearly £86bn last year, nearly 5% of GDP. This trade surplus on services more than offsets our deficit on trade in manufactures (£81bn). Both the level of services exports and the services trade surplus reached new highs in 2014.

Because services trade is less visible than goods trade, its importance tends to be underplayed. The UK is a remarkably successful exporter of services – second only behind the US in the world. Services exports account for around 12% of UK GDP, compared with around 8% in Germany and France, 4% in the US and 3% in Japan.

There are a number of myths about services trade which need to be dispelled. The first is that it is all about selling financial services, and therefore we are overly dependent on the City of London for our successful record of exporting services. In fact, the UK has a very diverse range of services exports. Banking, insurance and other financial services do contribute about a third of the total in the UK. But business and professional activities account for a quarter of our services exports. IT, travel and tourism, education and the creative industries – music, film, design, etc – also make a substantial contribution.

A second myth is that services trade does not add as much value to the economy as manufactures. In fact the reverse is true. Manufacturing industry is a big importer of components , energy and raw materials. So the value-added element of £1 of manufacturing exports is lower than the equivalent in the services industries. Work by the OECD suggests that UK services exports generate more value-added for the UK economy than manufacturing trade, not less.
A third myth is that we have exhausted the growth potential of our exporting services industries. Though services account for 70-80% of the output of major economies, their share of total world trade is just 20%. A concerted approach to breaking down barriers to trade in services – both within the European Union and more widely across the international economy – could support further rapid growth, as a recent report from the CityUK Independent Economists’ Group has argued. A PwC report in 2013 found that emerging market imports of services are now larger than the G7 economies – and were growing three times as fast.

Services trade is a big success story for the UK and services exports have significant growth potential. It is likely that within the next five years, UK services exports will exceed our overseas sales of manufactures. A strategic focus on breaking down barriers to trade in services, and maximising our export potential, should therefore be a priority for the next term of government – whichever party wins the forthcoming General Election.



Services trade should be a UK strategic priority | Guest Blog author | Andrew Sentance | Senior Economic Adviser PwC

Wild Card: Happy Mothers’ Day! UK trade in cut flowers

According to Delta Economics’ forecast data , the UK’s imports of flowers showed a healthy increase of 9.3% in March as the nation’s children bought their mothers well-deserved bunches of flowers for Mothering Sunday. Delta expects the UK to stick to this tradition with imports of cut flowers set to enjoy a compound annual growth rate of 1.1% per year over the next five years. However, we are also seeing a marked decrease over the same period of flowers imported from Ethiopia to the UK, down 3.8% on average per year.

Ethiopia is the fifth largest exporter of cut flowers world-wide and their flower exports are forecast to sprout up by 9.2% on average per year over the next five years. As our infographic indicates, growing exports of cut flowers are supported by budding imports of the components used in fertilisers, with India, China, and Germany as top trade partners in these sectors. Although Ethiopia’s trade in cut flowers lags behind the Netherlands’, the largest cut flower exporter, the bulk of their flower exports are bound for the Netherlands. Given that the UK are the third largest export destination for Dutch blooms, flowers grown in Ethiopia may find themselves sold by British retailers after all.

But flowers aren’t everyone’s thing. In fact we have noted stronger rates of growth in alternative luxury products. Imports of chocolate, perfume, and beauty products are all predicted to increase in the next five years, with compound annual growth rates of 2.9%, 1.29%, and 1.28% per year respectively. It appears that there are plenty of options to keep mothers happy.




Figure 1  |  Happy Mothers’ Day! UK trade in cut flowers
Source  |  DeltaMetrics 2015



Happy Mothers’ Day! UK trade in cut flowers  |  Author  |  Jennifer Ung Loh  |  Press Secretary and Analyst

UK exports show rates of improvements

With the UK’s general election rapidly approaching, it will have come as good news to all parties that Europe’s export orders to the UK were showing a marked increase. A quarterly survey by manufacturers’ organisation EEF and law firm DLA Piper reported findings that export orders were increasing and were moving out of negative territory for the first time in nine months.

Accordingly, Delta Economics forecasts that while the UK’s total exports to Europe are still falling, they will decrease at a slower rate from this year until 2018, when they will finally reach positive rates of growth. This is important and timely news for the major political parties vying for election success. Many parties have promoted ideas of policy refocus, particularly increasing the UK’s exports as a means of shifting the UK’s balance of trade further towards surplus.

However, the formation of effective policy to instigate this change will be tough. Delta Economics forecasts that the UK’s trade deficit is expected to decrease slightly over the next two years but will then continue to increase steadily for several years after that. Although this is worrying for the UK given efforts to address the deficit, investments into key sectors could help exports flourish.

For example, of its largest export sectors, the UK’s exports of meat are expected to grow by over 3% this year, suggesting that they are expanding international opportunities for the farming industry. Similarly, UK exports of clothing are also expected to be amongst the fastest growing sectors this year. This could also mark some significant opportunities for the British garment manufacturing sector.

What is becoming increasingly apparent in the policy structures that are emerging in the run up to the election is that the UK’s export industry has the potential to contribute significantly to the recovery and prosperity of the British economy. What remains to be seen is how well existing opportunities are nurtured and built into sustainable growth industries.




Figure 1  |  UK exports show rates of improvements
Source  |  DeltaMetrics 2015



UK exports show rates of improvements  |  Author  |  Nayani Bandara  |  Analyst and Project Manager

Webcast 030 | Lessons from QE in four charts

March 2015 marks the start of Quantitative Easing (QE) in Europe. Given broader uncertainty around the effectiveness of QE, what lessons can the ECB learn from QE in the US, Japan, and the UK?



Webcast 030 Author  |  Rebecca Harding  |  CEO

Lessons from QE in four charts

Why nothing should be taken for granted  |  March 2015 marks the start of Quantitative Easing (QE) in Europe. The much anticipated programme will inject €1.1tn into the eurozone’s coffers up to September 2016 at a rate of €60bn per month from next month. The European Central Bank will be purchasing national government bonds from member states and, in so doing, it will have become the “lender of last resort” in Europe at last ceding to demands that it provides a backstop to Europe’s fragile sovereign nations in the wake of the financial crisis.

While this has created an uneasy truce between markets and Europe, there is still a long way to go. With QE, systemic risk from sovereign default is avoided and the immediate impact has been to boost equity markets and weaken the value of the euro. Theoretically, this should boost confidence and exports. However, the volatility in markets at present is a product of the broader uncertainty around the effectiveness of QE. Markets need to be convinced that it was the right strategy in the first place, not least because of the broader uncertainties around European geopolitics at present, and are in a mood to test European policy makers in any way they can.

One of the principles of QE is that it reduces the value of the currency and thereby supports real economic growth through exports. Here are the lessons from that trade perspective in four charts:


Chart 1  |  US QE – market correction overdue




Figure 1  |  Monthly Value of US exports (USDbn) versus S&P 500, last price monthly
Source  |  DeltaMetrics 2015, Bloomberg


The chart shows the close correlation between monthly movements in trade and the S&P 500 at 0.715. Each horizontal line shows the start of a QE programme: December 2008, November 2010 and latterly September 2012. US exports during that time have grown modestly, while the S&P 500 has increased in value substantially faster than its pre-crisis rates, particularly since QE3 in 2012. It appears that one effect of QE has been to worsen the disconnect between asset values and the real economy up to the start of this year.


Chart 2  |  Abenomics and the paradox of the yen




Figure 2  |  Monthly value of Japanese exports versus JPY per USD spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


Japan’s relationship with QE has been a long one and has produced a bizarre result: except for the period between October 2004 and May 2007, the relationship between the strength of the yen and exports has been the reverse of what would be expected. As the value of the yen strengthened between June 2001 and October 2004, exports increased. Similarly, as the value of the yen decreased shortly before the implementation of Abenomics in 2012 through to Shinzo Abe’s final asset purchases in October 2014, export trade actually fell. This is a lesson for the developed world economies: exports are currency inelastic and therefore depreciation is unlikely to have much impact on export-led growth.


Chart 3  |  UK QE and the export mystery


The purpose of UK QE was arguably to protect against systemic risk and loosen up the supply of credit in the banking system to enable bank-to-bank lending. It did not have as its primary focus either exports or real growth. However, as the rest of the world started to pull out of the downturn in the wake of the financial crisis, the question of why sterling had depreciated so much without any impact on exports took on renewed importance. The Conservatives, elected in 2010, set export-led growth as its target and set a goal to double UK exports between 2010 and 2020 to a value of £1 trillion.




Figure 3  |  Monthly value of UK exports (USDbn) vs EURGBP spot (value of 1 euro in sterling), June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


UK QE started in September 2009 and was boosted further in October and November 2009. In October 2011 an additional £75bn in QE was announced followed by £50bn each in February and July 2012. Rather than causing the value of sterling to drop, the immediate market reaction was for it to strengthen. Interestingly, the terms of trade are negatively correlated with the value of sterling at -0.754. In other words, exports will grow in value in relation to imports as the value of the currency depreciates. This is exactly as it should be. Yet the facts demonstrate a very weak correlation (0.466) between the value of sterling and exports. QE has strengthened rather than weakened sterling, as in the US, especially against the euro but even so, sterling has not returned to its levels against the euro of 2001 and has therefore depreciated over the whole period, as have exports.


Chart 4  |  QE in Europe – a combination of both?


Previous trade views have expressed scepticism at the impact on trade of any reduction in the value of the euro. Like Japan, the eurozone’s trade is highly currency inelastic and, as a result, the depreciation of the euro is unlikely substantially to increase exports and therefore provide a much-needed boost to growth.




Figure 4  |  Monthly value of eurozone exports (USDbn) vs Dax Index, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


However, it is likely that the value of European stock markets could increase substantially. The Dax has reached all-time highs since QE was announced and this creates as substantial a disconnect between economic fundamentals and equities in Europe as there has been in the US and the UK. But this QE-induced asset boost, unlike in the US, comes without an accompanying boost to the real economy in the form of infrastructure spending. Instead, it may well come with restrictions on real growth if sovereign responsibility is tied to austerity rather than structural reform and long-term growth.

Policy makers in Europe now have to ask which lessons they want to learn, and from which chart.

The Fallacy of Quantitative Easing

There is no doubt the EU project has benefited the German economy above all else: a bit like the cat got all the cream and then some. But it cannot be put off any longer; as Voltaire once said, with great power comes great responsibility. In an unusual act of defiance against German apprehension to the ECB’s sovereign bond-buying programme, the ECB will press ahead with QE1. There will be a week to thrash out the exact details after the ECJ verdict on 14th January on the legality of such a move, but a formal announcement is expected on 22nd January.

The decision to “press the button” is more likely now than ever before given the falling prices in the Eurozone. Some would argue that we are being too quick to diagnose a deflationary spiral: that these are just temporary falls in prices. The truth is that falling prices were evident in the Eurozone long before the recent external (oil) supply shock took effect. Europe’s problems run much deeper.

In the short term, any announcement in QE is unlikely to be large enough or make a significant impact on economic fundamentals: much like plugging holes in a leaking dam. QE will only act as a plaster over the real structural differences that besiege the Eurozone. Indeed, some of the world’s major economies have implemented QE with dubious results: the USA has been through three rounds of QE with more favourable outcomes, however, whether that’s purely down to QE or other more dynamic variables has yet to be proven. The UK has gone through two rounds: with the first being more effective than the second. Japan on the other hand has had to endure NINE rounds of injections (yes, QE9!) with little effect. Even after 20+ years, the legacy of deflation is engrained and growth remains elusive.

In the more medium term, what is clear is that QE will contribute to bloating banks’ balance sheets, with little in the way of affecting the real economy. This is unlikely to prompt banks to lend more. On the contrary, the winners of QE will be the bond holders, mostly the well-off, whom are unlikely to spread to the gains evenly around the economy, but would rather pile into assets thus further perpetuating asset price inflation. It’s an inefficient allocation of resources: the “wrong” people are being targeted.

What else if not QE one might ask? Recent reports suggest that Japan is toying with the idea of implementing a more innovative monetary policy tool known as “helicopter money”: dropping money directly into the pockets of every citizen. Whilst this would target the “right” people, it may all be too radical for the bureaucrats of Europe. Many economists view this measure with great suspicion partly because it hasn’t been tested robustly enough. However, the belief that prices will fall further may already be entrenched into the minds of EU citizen, so any windfall in the way of helicopter money (if too small) may be squirrelled away rather than spent on stimulating the local economy. Introducing a voucher- based system for certain goods and services is marginally better, but this too comes with a host of complications in terms of which good and services qualify, and ensuring money is not leaked out of the system.
It will need more than QE to resuscitate the Eurozone. A Eurozone break up is out of the question no matter how necessary it may be in economic terms: politics will trump economics. What is more likely is that there will be QE-light – but this still falls short of what is really needed: further structural reforms and deeper fiscal consolidation. One thing is for sure: being timid never got anyone anywhere…


The Fallacy of Quantitative Easing  |  Author  |  Shefali Enaker  |  Economist

Scotland the Brave

In her role as Head of State, the Queen is expected to remain politically neutral so while she may express her concerns about the outcome of the Scottish Referendum on the 18th September, she can do little more than she did this week: hope that the Scots will “think carefully about the future” when they make their choice. Whatever happens on Thursday, the uncertainty around the next steps will make markets nervous about investing in the UK (or what remains of it) with the consequences that we have already started to see in terms of capital movements, the value of Sterling and the FTSE. Ordinary Scottish voters will not just have to think carefully, they will also have to be brave: this decision is irreversible.

At first glance, the exit of Scotland from the United Kingdom would harm the rest of the UK far more than it would Scotland. Removing oil exports from the UK’s trade balance would add roughly £1.6bn by the end of 2016 to an already burgeoning energy trade deficit. The trade deficit (net X) is already a drag on the UK’s GDP growth and adding to it would hamper what is still a fragile recovery.

According to UK government calculations, some 80% of Scotland’s GDP is dependent on free trade with the rest of the UK. This includes oil, of course, but equally financial services and whisky – two of Scotland’s other leading export sectors. In other words, a large proportion of Scotland’s economic performance relies on the performance of England, Wales and Northern Ireland. For the “Yes” campaign this is the essence of the reason why independence is a good thing: freedom from the rest of the UK gives the Scots control over their economic destiny.

But there is something slightly misleading in this line of argument; the UK is arguably the world’s oldest and most successful currency union and Free Trade Area. The Bank of England is, already, the lender of last resort ready to support Scottish banks and the Scottish deficit with UK taxpayers’ money while Scotland currently has substantial fiscal and political autonomy.

If Scotland votes to leave the UK, then on Friday 19th September policy makers in Scotland and the rest of the UK have to work out the terms under which Scotland can join a currency union as an independent nation. Effectively, it would face the same challenges as the Eurozone: how to integrate a deficit nation into a structure where a transfer union (i.e. cross-border tax transfers) would be necessary to correct the internal imbalances between members. A transfer union would legitimately be frowned upon by UK taxpayers if Scotland had its own tax-raising powers. But it would ensure that the lender of last resort (i.e. the Bank of England) does not have to loosen fiscal policy through greater Quantitative Easing in order to underwrite the Scottish deficit. This deficit currently stands at around £12bn and will grow if, under Scottish independence, the new administration undertakes to deliver on its expansionary promises.

Finally, the United Kingdom is also the world’s longest standing and most successful customs union. Scotland, England, Wales and Northern Ireland take the free movement of goods and services across borders for granted. This creates all the advantages of a customs union: economies of scale, access to larger markets and lower costs and prices. Some large companies have already warned of the dangers of higher costs, even without the costs of tariffs should no agreement on a common currency be reached. The consequences of ending a currency union may well be the end of the customs union too. How much of Scottish GDP might be affected by that? Quite apart from the political and economic issues that such a situation would create, is the fact that if the Scots vote “Yes”, they are voting for more independence, not less. Yet the paradox of exiting a currency union and then re-joining it is that they may well end up with more dependence and less freedom over fiscal policy than they currently have.

These are technical issues that have given the “No” campaign a reputation for being dull and un-engaging. It is, after all, hard to get really passionate about free trade areas and transfer unions. Yet these are the issues that will determine the long-term economic outcomes, not just for the Scottish people but for the whole of the UK and potentially for Europe as well. “Think carefully” hardly sounds like a wake-up call, but it really is!


Scotland the Brave  |  Author  |  Rebecca Harding  |  CEO

Lost interest?

What do England’s exit from the World Cup and a pending interest rate decision have in common?  |  Since Mark Carney hinted that UK interest rates might rise by the end of 2014 in his Mansion House speech on the 12th June, Sterling has strengthened, reaching a peak against the Dollar last seen in 2009. By the end of the week, Sterling had slipped back slightly and the debate had focused again on how this would affect the enduring problem of UK growth: that without a seismic shift in the productive, and hence export, capacity of the economy, any chance of sustainable recovery remains in the hands of Britain’s consumers. In essence, this is the same as leaving the chances of getting out of the group stages of the World Cup to Italy or Costa Rica. And we all know what happened there.

It is a mistake to think that interest rates changes are going to make much difference to exports at all. For example, the correlation of the USD-GBP spot with exports is only 0.41 while for the GBP-Euro rate it is 0.46. Similarly imports are only 0.38 correlated with the USD-GBP spot and 0.56 correlated with the GBP-Euro spot. In other words, don’t expect interest rates to make much difference to trade at all.

The mystery is why anyone should be surprised at this. Figure 1 shows the two currency spot rates (USD per Pound Sterling and Euro per Pound Sterling) against the one-month Libor rate.



Figure 1  |  The USD-GBP and GBP-Euro spot price, Last Price Monthly, June 2001-May 2014

Source  |  Bloomberg


Over the time period, the volatility in base rates is relatively clear to see, as is the dramatic drop in interest rates to near zero as a reaction to the financial crisis. The substantial reduction in the value of Sterling against the dollar and the Euro between 2007 and 2009 can also be seen. And although there has been a slight improvement in the value of Sterling against both currencies over the past 12 months, this is both independent of interest rates, since these have not changed and, more importantly, in no sense a recovery to the pre-crisis levels. What is interesting about Figure 1, however is the fact that the relationship between interest rates and the value of Sterling against the Euro is much stronger at -0.80 compared to short term interest rates against the value of the US dollar against Sterling, where the correlation is 0.64. In other words, UK interest rates are more likely to provoke a sharper correction of Sterling against the Euro than they are against the dollar.

But whether or not this will impact trade is debatable. Figure 2 shows the historical relationship between short term interest rates and trade over the period since 2001.



Figure 2  |  The Value of UK exports and imports (USDm) versus short term base rates, June 2001-May 2014

Source  |  DeltaMetrics 2014, Bloomberg


Mark Carney is clearly correct to think he can gamble on raising interest rates and it having a minimal effect on trade: the correlation of short-term base rates with exports over the period is -0.18 while for imports it is -0.25. While this is, of course, purely for illustrative purposes, it points to something that economists have suspected for a while of UK trade: that a change in interest rates that leads to a change in the value of the currency will have little or no impact on levels of trade. There has been a near 25% reduction in the value of Sterling since 2008; there has not been a commensurate increase in trade.

Figure 3 illustrates how the Terms of Trade have changed against the value of Sterling against the Euro and against UK base rates.



Figure 3  |  UK Terms of Trade versus GBP per Euro spot, Last Price Monthly, June 2001-May 2014

Source  |  DeltaMetrics 2014, Bloomberg


There is a strong correlation over the period between the strength of the pound against the Euro and the terms of trade of 0.75. In other words, if Sterling strengthens, then the terms of trade over the period will also improve: exports will become more expensive relative to imports. This would almost be a truism were it not for the fact that the equivalent correlation with the Dollar is 0.18 – i.e. there is practically no relationship at all. So why would there be such a difference between the two exchange rates?



Figure 4  |  Why UK trade with Europe is more vulnerable to a change in interest rates

Source  |  DeltaMetrics 2014


First, Europe accounts for 43% of UK goods trade and the US 10%. The UK’s top sectors are medicines, oil (crude and refined), cars and turbo-jet engines and turbines. The US is the biggest destination for both pharmacueticals and turbo jets engines and turbines, and the third and second largest destination for crude and refined oil respectively. Nevertheless, thirteen of the top 3 export destinations for Europe’s top five products are in Europe, helping to explain why the value of Sterling against the Euro is more important than it is against the dollar to UK trade.

Second, the USD-GBP rate is used more for speculation. Across the piece, its correlations with trade are weaker: the Euro is a trade-based currency so Sterling’s value against it is determined by trade rather than by speculation. This may make UK export trade itself more vulnerable should interest rates rise.

Relying on small-scale and incremental interest rate changes is likely to have little impact either on the value of Sterling or on the UK’s trade. The reason for putting up interest rates is usually to quell inflationary tendencies by making the cost of borrowing more expensive. In this case, the goal will be to dampen pressure on house prices which may create unsustainable growth in the UK economy.

But look again at Figure 2 and the trend in exports since September 2011. The values are actual historical values of trade and while the seasonal fluctuations in trade are clear, what is also obvious is a downward pressure on the value of UK exports in US Dollar terms. In other words, we are already seeing disinflationary tendencies affecting the value of UK exports. If interest rates do go up, this puts further negative pressure on inflation, which could create similar downward pressure on UK export prices in spite of a strengthening currency. The danger then would be of deflation brought on by the very instrument that was meant to be a cure: interest rates.

As a recent leader in the Financial Times* pointed out, the issue is one of a large productivity gap between the UK and the rest of the world, particularly the US and Germany. This weakens our manufacturing trade position and, arguably, makes UK exports uncompetitive not in price terms but in terms of the added value embodied in our high-end manufactured goods.

As was pointed out in a previous Trade View, the correlation between skills and UK trade is low at just 0.54 compared to figures of between 0.94 and 0.98 in the US, Germany and India and unless this gap can be closed, our progress towards global high-end competitiveness will be restricted by our productivity base. Like the post World Cup inquest, maybe we should be looking at the drivers of our own weak performance and not at the dominance of foreign players in our markets.


* Leader (June 13th 2014) | ‘Carney’s journey from dove to hawkFinancial Times


Be wary what you wish for

Why the anti-European protest movement is missing the point | As the dust settles from last week’s European Elections one thing will be quite clear: there is a real momentum behind anti-establishment and Euro-sceptic protest parties across the continent.  From the “Alternative für Deutschland” (AfD) party promoting Germany’s exit from the Euro, through the Front Nationale in France, to UKIP (UK Independence Party) advocating the UK’s exit from Europe altogether, the mistrust in established politicians is manifest.  Beyond the clear fact that voters are frustrated with national politicians, the core of Euro-sceptic sentiment is rooted in anger, indeed frustration, at the failure of Europe’s politicians to create economic security for its voters because of the tortured recovery from the financial and sovereign debt crisis, perceived threats to job security from immigration and a failure of European institutions more generally.

As Europe and the UK’s mainstream politicians start to re-calibrate their dialogue with the electorate about Europe, they would do well to focus on trade, not least because one of the two founding principles of the European Union was free trade between Member States.

Trade is central to understanding why European Union is important.  First, take the country with the most vocal advocates of European exit, the UK.  Trade with Europe was worth an estimated £301bn to the UK economy in 2013 and the Centre for European Reform (CER) estimates that some 30% of the UK’s total trade is reliant on membership with the EU.  Second, there are signs that economic conditions in Europe are improving: our forecast for European trade has risen from a negative forecast for 2014 three months ago to a flat growth forecast (-0.08%) now reflecting an improvement in underlying drivers of trade included in Delta’s model, including lower market volatility, improved GDP and greater migration which improves the downward pressure on trade of aging populations.

Europe remains a long way from sustained growth, still less rapid growth, but there are positive signs of internal rebalancing since Mario Draghi’s commitment to “do whatever it takes” to ensure that the Euro did not collapse.  But while Mr Draghi concentrated on the need for the ECB to shore up the Euro as required, the Delta Economics view is that Europe’s longer-term solutions lie in its international competitiveness represented through its external trade balance.  Figure 1 shows why we see this as the case.



Figure 1 | The Value of EU 28 and Eurozone trade (USDm) versus the USD per Euro exchange rate, Lat Price Monthly, June 2001-April 2014


What is remarkable about the relationship between the value of Europe’s and the Eurozone’s exports and the USD-Euro currency spot price is the strength of the correlations: 0.86 NS 0.87 respectively.  In itself, this helps to explain why, even at the depth of the sovereign-debt crisis there was never a serious or sustained run on the Euro.  The currency is a trade currency and this means that it is less vulnerable to speculative volatility.

Similarly, European markets are also highly correlated with EU28 and Eurozone trade.  Taking the DAX as a proxy, the correlations are 0.76 and 0.75 respectively, as illustrated in Figure 2.




Figure 2 | The value of EU 28 and Eurozone Exports (USDm), June 2001-Dec 2016 versus the DAX Last Price Monthly, June 2001-April 2014


Figure 2 shows a weaker correlation with the value of the Euro since mid 2011 for the Eurozone reflecting the sovereign debt crisis, the relationship between  EU 28 trade and the value of the Euro has remained strong, suggesting that the DAX reflects the economic fundamentals of trade to a greater extent than does, say, the FTSE 100.

Figure 3, which shows the relationship between the value of the UK’s exports to the EU and shows that, although the relationship is weaker (correlation of 0.69) the UK’s trade relationship with Europe is an important driver of market sentiment.




Figure 3 | Value of UK exports to the EU (USDm), June 2001-Dec 2016 vs FTSE 100 Last Price Monthly, June 2001-April 2014


What all this suggests is that the value of the Euro and key European stock markets are highly linked with European trade generally and UK trade with Europe in particular.  The UK’s trade with Europe is even reasonably correlated with the value of the DAX at 0.64.  In other words, markets can use trade statistics as a proxy for underlying fundamentals and react accordingly. Indeed, unlike the S&P 500, which appears to have gone in the opposite direction to trade recently, European markets seem to reflect European trade quite closely.  The conclusion? That Euro-sceptic political parties do not need to worry as much as they thought about economic mismanagement if a focus on long term growth, competitiveness and trade can supersede the shorter-term focus on austerity and rebalancing over time.

During the course of the next year, however, Europe’s politicians need to worry about the consequences of a potential UK exit from Europe, following the proposed referendum should the Conservatives win the next election.  The debate will focus around the benefits to the UK of European membership and a cursory look at the correlations between the USD-Euro, Sterling-Euro and Sterling-Dollar spot prices confirms that the value that the UK extracts from its EU in currency terms is far less than the value that the EU gets from its trade with the UK.



Figure 4 | Why Europe matters to the UK
Source | Delta Economics (Estimated proportion of trade dependant on EU – Centre for European Reform)


The correlations are much stronger between UK trade with Europe and the value of the Euro than they are for the value of Sterling, particularly against the Euro where the correlation is minimal.

This is hardly likely to have an impact on the average British voter, however, and, far from suggesting that the UK’s trade with Europe is valueless in currency terms, the fact that the correlations are weaker simply illustrates how the value of Sterling is more volatile in response to market sentiment rather than economic fundamentals.  Actually, as Figure 4 suggests, the value to the UK economy of trade with Europe is significant and, if the UK were to exit from the EU then the country would lose some £425bn, or over £6,000 per head of population in lost export trade value by 2022.

More than this: our forecasting model suggests that trade is highly correlated with skills, at some 0.98 across key countries in the European Union, the US and India.  In other words, across the developed and the emerging world, higher skills lead to more trade.  Here the UK has a gap with its European competitors: the skills component of trade is actually mildly negatively correlated with trade itself at -0.30 where it is 0.98 in other European countries.  In other words, the bulk of UK trade is currently not skills dependent and on the face of it may actually benefit from having lower skills (and hence lower costs) associated with it. Similarly innovation is only mildly positively correlated with UK trade at 0.35.

Two other countries with skills and innovation correlations like this are Brazil and China suggesting that the UK could easily lose out to lower cost nations if the bulk of its trade remains at this lower value end unless it can find cheaper ways of producing the same goods. Reports in May suggested that migration may actually have a positive effect on trade by reducing costs.

But there are two significant issues with assuming a low cost-low skill trade base for the UK is adequate. The first is one of principle: the UK should remain competitive at the higher value end of goods trade where innovation and skills are highly correlated with trade and where cost is less important. It is imperative that it increases the innovation component of its trade and recruits people with the skills to work in an innovative and international environment.  The second is one of practicality: if the UK is to find the people to take these roles, then it will have to compete with the rest of Europe as well as emerging economies like India which have high correlations of trade with skills and innovation. Accessing wider skills and innovative capacity through immigration is a central pillar of a strategy to build high-end competitive.  For example, Germany, having identified skills shortages in its productive and exporting base a decade or longer ago, now has its highest net-migration since 1993.

If Europe’s economy is improving, the benefits of trade to individual member states so great and the benefits of migration in skills and innovation terms so clear, Eurosceptics would do well to remember to be wary what they wish for.