The prospect of Brexit has ushered in a period of sterling weakness. This reflects uncertainty about where the UK is going, and the increasing likelihood that Brexit will seriously affect the long-term prospects for its economy.
Over the coming decade Brexit will mean the loss of many jobs in UK businesses exporting to the EU. If overall UK unemployment is not to rise, these job losses will need to be replaced by jobs growth in firms which can prosper in the new trading environment. The only way to do this is for the UK to improve its competitiveness. The fall in sterling is a key means to make that happen.
While, in Ireland, competitiveness was restored by cutting domestic prices, including wages, this was a painful way of making such an adjustment. The weakening of sterling is achieving the same effect for the UK, lowering real UK wages.
Given much higher import prices as a consequence of sterling’s weakness, the UK rate of inflation is now expected to peak at 3 per cent and remain close to that level into 2019. With slowly rising wage rates and a higher rate of inflation, UK workers are suffering an immediate cut in living standards in preparation for Brexit.
There will be further instalments of this painful medicine as the full effects of Brexit play out.
Rising real earnings
The short-term effect of Brexit for Ireland has been the direct opposite – weaker sterling means lower import prices, keeping inflation below the rise in wage rates here. This has resulted in rising real earnings, benefiting Irish consumers.
However, the fall in sterling as a consequence of the Brexit referendum has posed significant short-term problems for Irish firms selling into the UK market. In turn, it has also set in train an adjustment process in Ireland that will reduce, but not eliminate, the negative effects of sterling weakness.
Recent research by the Central Bank shows that a fall in sterling translates reasonably rapidly into slower inflation in Ireland. Already Irish inflation since May 2016 has been 2.8 percentage points lower than in the UK.
A key channel is the behaviour of UK retailers in Ireland, who source much of their product in sterling. Their pace of adjustment of Irish selling prices is much slower than it was in the pre-euro days, but such adjustment is nonetheless inevitable.
Cross-Border shopping
For consumers, the most obvious effect of the weakness of sterling is that it becomes significantly cheaper to shop in the North, or online with UK chains, rather than at home. While this price advantage for the North will be eroded gradually by lower relative inflation in Ireland, the adjustment will be quite slow. If there were increased competition in the Irish retail market, through entry by more firms with European supply chains, the adjustment would be much faster.
Thus new entry by retail firms from other EU states, such as France, should be encouraged, to provide competition to those retailers that are integrated into the UK market, in the same way that Aldi and Lidl help keep Tesco on its toes.
Differential inflation rates in Ireland and the UK as a result of weaker sterling will, over time, reduce but not fully eliminate problems for Irish firms selling into the UK.
With the bulk of Irish firms selling into the UK pricing in sterling, the initial effect of the sterling shock is to greatly reduce their profit margins. In the medium term, this, in turn, will result in some reduction in the price food processors will pay for agricultural inputs, as well as some eventual increase in their prices on the UK market.
However, in the long run, there is likely to be a permanent loss for Irish manufacturers selling into the UK, as well as a loss in income to farmers from lower produce prices.
Some Irish business groups have suggested that affected Irish firms need special State aid from the Government to deal with the shock.
Apart from being illegal under EU rules, the last 40 years have shown that the State should target firms with growth opportunities rather than trying to protect industry with problems. The best strategy for firms to deal with Brexit is to seek alternative markets.
In particular in the food industry, this will require investment by the affected firms in product development and marketing to break into other markets. Temporary assistance to undertake such a transformation may be necessary, but the key to success lies in firms’ own hands.
