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Sterling: no solution

But would a weaker pound really be so bad? Conservative MP John Redwood thinks not. He said: “If the pound really did fall there’d be a big boost to exports and reduction in imports and a lot of the balance of payments problem would go away.”

This is too optimistic. A fall in sterling would not do much to close the trade deficit, simply because export and import volumes do not respond very much to price changes.

Recent history teaches us this. Between January 2008 and July 2009 sterling’s trade-weighted index fell by 14 per cent. But the trade deficit widened thereafter.

The OBR’s economic model estimates that a one per cent fall in the relative price of non-oil exports eventually leads to a rise in export volumes of 0.74 per cent. The response of imports is even smaller. “The demand for goods imports is not very sensitive to prices” says the OBR. It estimates that a one per cent rise in relative prices reduces non-oil import volumes by only 0.32 per cent in the long-run.

These numbers imply that the trade deficit would actually increase after a fall in sterling.

As a first pass, let’s do the maths. Last year, the UK’s non-oil exports were £264.6bn. Let’s say sterling falls 20 per cent, so exports in foreign currency terms become 20 per cent cheaper. The OBR’s model tells us this would raise export volumes by 14.8 per cent (20 x 0.74), raising exports to £303.8bn. The same 20 per cent fall in sterling would raise import prices by 20 per cent, but cut their volumes by just 6.4 per cent. That gives us an overall rise in nominal imports of 13.6 per cent. This would take them from £381.8bn last year to £433.7bn. Net, the non-oil trade deficit actually widens, from £117.2bn to £129.9bn.

Only if the OBR's estimates are wildly wrong would a fall in sterling reduce the trade deficit by "a lot."

Now, that’s just a first pass. There are three complications here.

First, a change in relative prices is not the same as a change in the exchange rate. In practice, many exporters would respond to the weaker sterling by raising their foreign currency prices, and overseas exporters would cut sterling prices. This is a two-edged sword. On the one hand, it means import prices won’t rise as much as sterling falls. But on the other, it means export volumes won’t increase so much either.

Secondly, global supply chains mean that, insofar as exports do increase, so too must imports.

Thirdly, Brexit would increase uncertainty in two ways. One would be about sterling: exporters might fear that it would over-react to near-term uncertainty, and so subsequently recover. The other would be about trade arrangements: would UK exporters face obstacles to trading with the EU? On both counts, exporters might reduce their investment in export activity, so the volume response to the weaker pound might be even smaller - at least in the short-run - than usual.

A fall in sterling would not therefore make “a lot” of the balance of payments problem go away. For that to happen, we need to see a revival in overseas demand. Which looks like a forlorn hope.