Ruth Lea CBE, Economic Adviser to Arbuthnot Banking Group looks at what is in for the UK economy in the decades to come.

There is little doubt that the UK economy is still in the top ten of the world’s largest economies, but its precise position is often disputed, owing to the different measures of GDP adopted by competing protagonists. So, before looking at the UK’s international standing, it is relevant to assess the relative merits of the relevant data. One frequently quoted, and highly respected, source of international data is the IMF, which lists four main measures for any country’s GDP: two in national currencies and two in US dollars.

The relevant data for the UK is shown in chart 1 for the years 2000 to 2017. The first measure relates to GDP in current prices in sterling, the blue line in the chart overleaf. Inevitably, growth in current prices reflects both price changes and volume changes so the statistical authorities deflate the current price data with GDP price indicators (calculated to a base year, in this case 2015) to obtain the constant prices data, which reflect the volume changes. The constant price data, the secondmeasure of GDP, is represented by the orange line below and clearly show GDP growth in volume terms has been significantly more subdued than in current prices. Specifically, the dip in output in 2009 is clearly more marked in volume terms than in current prices.

Suffice to say when it comes to international comparisons, data in national currencies have to be converted into a common currency in order for the comparisons to be made. Unsurprisingly, the common currency used is the US dollar, as it remains the most widely traded. But this is where another set of problems arise. When the data is converted using market exchange rates (MERs), the IMF’s third measure of GDP, the resulting data can be distorted by the quite violent fluctuations in exchange rates.

As can be seen from chart 1 (the grey line), a stronger sterling in the run-up to 2007, reflecting a weakening dollar, significantly boosted UK GDP in dollars. While GDP in sterling terms increased by about 40% (cumulative growth) between 2000 and 2007, it had soared by 85% in dollar terms. Concomitantly, the movements in the exchange rate were really quite substantial. In 2001 the average $/£ rate was $1.44, but by 2007 sterling had appreciated to an over-valued $2.00. Fortunes partly reversed when the pound weakened during the Great Recession, slipping to $1.55 in 2010, but they reversed again and sterling had firmed to $1.65 by 2014. A combination of a stronger dollar and the after-effects of the Brexit referendum in June 2016, then saw the average rate slide in 2015 (to $1.53), in 2016 (to $1.35) and in 2017 (to $1.29).

Clearly, international comparisons using MER conversion rates can dramatically mislead as to the relative sizes of the economies. In an attempt to avoid the pitfalls of fluctuating market exchange rates, the IMF’s fourth GDP measure involves the concept of purchasing power parities (PPPs). Exchange rates in PPP terms are the rates at which the currency of one country (say sterling) would have to be converted into that of another country (say US dollars) to purchase the same amount, or “basket”, of goods and services in both countries (in this case, the UK and the USA). Putting aside the huge methodological and computational problems, chart 1 (the yellow line) does illustrate that the IMF’s PPP data is a much better representation of developments in an economy than the MER data. The PPP data (which is, of course, in current prices) clearly mirror the current prices data denominated in sterling in a way that the MER data do not. Incidentally, the PPP data imply that the sterling, having being overvalued for years, may now be undervalued.

There are two other points to note about MER and PPP data. The first point is that several developed countries have a higher GDP in MERs than in PPPs, while emerging market and developing countries tend to have a significantly lower GDP in MERs than in PPPs. For example, Swiss GDP in 2017 was $679bn (MERs) or $517bn (PPPs), whilst Indian GDP was $2,611bn (MERs) or $9,459bn (PPPs). Note, however, that as countries get richer, their currencies tend to appreciate and the nominal MER GDP estimates tend to converge with the PPP GDP estimates.

The second is that GDP data at market exchange rates (MERs) provide a better measure of a country’s international purchasing power, so relevant for assessing potential export markets, than PPPs. Though on this second point, a country’s income per capita is also a critical factor. On this metric, developed countries still have a very appreciable lead over emerging and developing countries. According to the IMF, income per capita (in 2017) was over eight times as high in Switzerland as in India in PPP terms, but over 40 times as a high in MER terms. The corresponding figures for China were still as high as nearly four times and over nine times respectively.

Which are the biggest economies?

Moving to international comparisons, chart 2 comprises GDP data for the world’s ten largest economies in both MER and PPP terms. Starting with MER GDP data, the US remained a clear leader in 2017, still over 60% greater than second-placed China, despite China’s spectacular growth rates in recent years. These two economies are appreciably larger than the rest of pack and they can be assigned a tier to themselves – the “top tier”. Dropping down to the second tier, Japan remained the third largest economy, despite years of sluggish growth, comfortably ahead of Germany, easily Europe’s largest economy. The UK retained the fifth position in 2017, marginally ahead of fast- growing India, but India may be expected to overtake the UK in 2018 and pull strongly ahead in the years to come. France, Brazil, Italy and Canada make up the remaining top ten in MER terms.

The picture in PPP terms for 2017 changes somewhat, not least of all reflecting our previously made observation that in emerging economies GDP in MER terms tends to be significantly lower than in PPP terms. This is clearly the case for China, which easily outstripped the USA for pole position in 2017. But it also applies to third placed India, fifth placed Russia (12th in MER terms), sixth placed Indonesia (16th in MER terms) and Brazil, now ahead of the UK and France. The UK was, however, in a perfectly creditable ninth position in 2017, followed by France.

All in all, therefore, the UK remains a significant second tier economy, however one chooses to measure GDP.

The world economy will continue to change – but the UK looks set fair

The UK is an internationally significant economy and, moreover, is expected to remain a major economy in the decades to come despite the seismic shifts taking place in the global economy.

The world economy has, of course, changed profoundly in recent decades, as growth in the emerging economies, not least of all China and India, has far outstripped growth in the mature developed countries, especially in Europe. Further profound changes are expected in forthcoming decades. The OECD has recently released an interesting exercise, which looks ahead to 2060.1 Crystal ball gazing so far into the middle of the 21st century is fraught with problems but, nevertheless, such exercises can be instructive, providing their limitations are acknowledged.

The OECD’s “baseline scenario” suggests that world trend real GDP annual growth would decline from the current rate of about 3.5% (annual average for the decade 2010-2020) to 2% (annual average) for the decade 2050-2060, as shown in chart 3. The sharp deceleration mainly reflects the slowdown in India and, especially, China, as “catch-up” with the world’s richer economies loses some of its impetus and, in the case of China, adverse demographic developments depress growth potential. Nevertheless, given the still relatively buoyant growth of India and China (at least up to 2040), the world’s economic centre of gravity continues to shift toward Asia. Japan remains a laggard in Asia, with annual growth averaging just over 1% to 2060, partly reflecting the economic effects of the ageing population. The USA is expected to maintain annual growth rates of around 2%, though these may prove to be underestimates.

And the UK? The OECD expects the UK will continue losing share up to and including 2030-2040 as world growth outstrips UK growth, though the UK would clearly remain a sizeable and growing world economy. Thereafter, the OECD is increasingly sanguine about prospects. The UK could maintain, if not regain, share as growth equals, if not exceeds, world growth. Germany’s growth rate, meanwhile, is expected to sag, reflecting adverse demographics.

Supplied by Tom Martin at Arbuthnot Banking Group

Reference

1. OECD, “The long view: scenarios for the world economy to 2060”, July 2018.

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