How is Brexit affecting the role of sterling in UK trade?

In the five years since the Brexit referendum, the share of the UK’s exports invoiced in pounds has declined, while invoicing in US dollars has grown significantly. Such changes matter for the competitiveness of UK exporters, particularly if there are sudden shifts in currency values.

An important change has been taking place in the UK’s trade with non-European Union (EU) countries. Since the Brexit referendum, the country’s trading relationship with the EU – which remains its largest trading partner – has taken centre stage in the policy discussion. But since the vote in June 2016, the importance of the US dollar in UK exports has been rising, while the importance of sterling has been falling.

Between 2010 and 2019, the share of the UK’s exports of goods to non-EU countries invoiced in dollars rose by 52.9%, from just under a third of non-EU export value in 2010 to nearly half in 2019. The pound was used for invoicing over 60% of total UK exports to non-EU destinations in 2010, but this share had fallen dramatically to 41% by 2019. Over the same period, the importance of the dollar for UK imports rose by a mere 5.7%.

These changes in the invoicing of UK exports matter because the currency used is closely linked to the degree to which firms alter their prices in response to exchange rate movements (what is known as exchange rate ‘pass-through’). One study of UK imports found that in response to a 10% fall in the value of sterling, the price of UK imports invoiced in sterling did not change. But the price of imports invoiced in the currency of the producing country rose by 6.2%, while the price of imports invoiced in dollars rose by 5.9%.

Another study highlights how the prevalence of dollar invoicing in global trade is driving systematic differences in how import prices adjust in response to changes in the value of an economy’s currency (Gopinath et al, 2020).

For the United States, movements in the value of the dollar against other currencies lead to very small changes in the price of US imports. This fact, which is known as low exchange rate pass-through, implies that global economic shocks are unlikely to affect the US economy via trade in real goods.

For other countries, a high share of imports invoiced in dollars implies that the country’s import prices will increase substantially if its own currency falls in value relative to the dollar – that is, the country has high exchange rate pass-through. This means that the country is vulnerable to global shocks.

What these studies show is that firms' invoicing choices are key to deciphering the global transmission of economic shocks across countries, as well as understanding the impact of a currency depreciation on the price competitiveness of a country’s exporters.

What is the role of the dollar in global trade?

Most international transactions are invoiced in only a handful of currencies, with the dollar being dominant globally. The currency has been used to invoice about 40% of world trade flows in recent decades – which is three to four times larger than the United States’ own share in world trade.

Economists have examined the factors underpinning firms’ choices of invoicing currencies. One study examines a firm's strategic incentive to choose the same currency as other exporters, using cross-country data on the shares of different invoicing currencies (Goldberg and Tille, 2008).

The analysis suggests that the prevalence of dollar pricing arises from strategic behaviour by firms. For example, the substitutability of homogeneous goods sold by different firms tends to be high. This indicates that even a small increase in one firm’s price would lead to a substantial reduction in sales.

Thus, a firm selling these highly substitutable goods would strategically choose to invoice its export sales in the dominant currency used in a destination, which is most commonly the dollar. By doing this, the firm can maintain a stable price relative to its competitors in a destination, even when the currency used in its own country fluctuates in value. In turn, this relative price stability ensures that a firm’s sales volume will also remain stable.

More recent work has used large firm-level datasets to study the use of different invoicing currencies by firms. One study investigates Belgian firms' trade with non-EU destinations, documenting that larger firms are more likely to invoice in dollars while smaller, less import-intensive firms tend to invoice in euros and exhibit almost complete exchange rate pass-through into foreign import prices (Amiti et al, 2020).

Although the share of a currency in a country’s trade has important implications for policy and firms’ profitability, due to limited data on invoicing over time in most countries around the world, how a particular currency comes to dominate the invoicing of world trade flows is not well understood.

Analysing the dynamics of firms’ currency choices can help to predict the rise of other currencies such as the euro or China’s renminbi to dominant roles in world trade. It can also help to shed light on the long-run effects of major economic events such as Brexit.

What about the role of the dollar in UK exports?

The UK’s firms are particularly interesting for studying invoicing currency choices because UK exporters use a wide variety of invoicing strategies. Previous research has shown that 99% of the UK's non-EU export value originates from firms using at least two currencies (Corsetti et al, 2020). Indeed, half of the UK’s export value originates from exporters using at least two different currencies to invoice sales of the same product to the same foreign destination within a calendar year.

UK exporters also actively switch the currencies used to invoice exports over time. This suggests that examining the factors that influence UK exporters’ choices of currencies could be informative about changes in the use of currencies around the globe and over time.

Studies of international pricing have emphasised two forces that influence currency choice. The first is the currency choices of a firm’s competitors. If more competitors use dollars in a foreign destination, a firm is more likely to invoice its exports in dollars to keep its prices stable relative to its competitors in the face of exchange rate movements (Goldberg and Tille, 2008).

The second factor is the currency of a firm’s imported inputs. Firms with a larger share of imports invoiced in dollars have a greater incentive to use dollars for their exports too, in order to insure against (or ‘hedge’) exchange rate risk (Chung, 2016; Amiti et al, 2020).

There is a third factor – the managerial cost of using a foreign currency – which adds another layer to the problem (Crowley et al, 2021). This can be thought of as a fixed cost, such as hiring a person to manage each currency used by a firm, and it suggests that there is a potential advantage to using the same currency for multiple transactions. The ‘returns to scale’ of using a given currency lead to a rise in the use of the dollar among UK exporters as their accumulated experience with that currency grows.

Analysing UK exporters between 2010 and 2016 highlights the importance of a firm’s previous experience with dollars in determining its future invoicing choices. Figure 1 shows the estimated effect on dollar invoicing in a new market associated with the number of previous years of using dollars. As shown, firms with more years of dollar experience are more likely to choose dollars for invoicing in a new market.

At one extreme, a firm with six years of dollar experience is 14 percentage points more likely to invoice in dollars in a new market, relative to firms that have never used dollars in any foreign market. This evidence suggests that previous experience with dollar invoicing has positive feedback on future currency choices.

Figure 1: The effects of dollar invoicing experience on dollar invoicing in new markets

Source: Crowley et al, 2021, data from HMRC overseas trade in good statistics, UK’s non-EU export transactions, 2010-16

Building on this, Figure 2 reveals how a firm’s use of dollars for invoicing exports is not only influenced by the number of years it has been using the currency, but also by the number of years it has been exporting its goods or services. Firms with longer export tenures tend to be larger and might be expected to favour dollars simply because of their size.

Looking at firms that have been exporting for different lengths of time, research shows that regardless of whether a firm has been exporting for two, three, four or five years, the probability of dollar invoicing in a new market rises with the firm’s previous experience with dollars (Crowley et al, 2021). This tells us that it is experience with dollar invoicing rather than simply experience with exporting, that leads to the change in dollar use over time.

Figure 2: The impact of dollar invoicing years by exporting year cohort

Source: Crowley et al, 2021, data from HMRC overseas trade in good statistics, UK’s non-EU export transactions, 2010-16

What are the implications of rising dollar dominance for UK trade?

The evidence on rising dollar dominance has two important implications for UK trade:

First, in response to large economic shocks such as Brexit or Covid-19, firms’ currency choices might be slow to adjust. This happens because a firm’s current currency choices are heavily dependent on its historical invoicing patterns.
Second, any adjustment to invoicing that a firm makes today will have a significant influence over the firm’s currency choices in the future.

In the immediate aftermath of the Brexit referendum, the aggregate shares of different invoicing currencies remained relatively stable, despite the large drop in the value of the pound. But over the post-referendum years, the aggregate sterling share declined, and the aggregate dollar share rose gradually, suggesting that UK firms were slowly adjusting their pricing and invoicing strategies.

Importantly, these post-Brexit adjustments are likely to have substantial long-run effects on the overall pattern of currency usage in the UK’s global trade. The full impact of Brexit and its associated large sterling depreciation may take decades to materialise fully.

It is important that UK policy-makers take account of continuing changes in the use of currencies by UK firms because this could shift the patterns of transmission of international shocks into the UK economy.

Where can I find out more?

Dominant Currencies and the Limits of Exchange Rate Flexibility: The IMF blog provides some statistics on the use of dollars for invoicing trade to and from emerging economies.

Gita Gopinath’s Hahn lecture at the annual conference of the Royal Economic Society in 2017 provides an overview of the importance of dominant currency pricing to the global economy.

Information on changes in the use of different currencies by firms in the UK can be found in UK Non-EU Trade in Goods by Declared Currency of Invoice 2019 data (UK Gov).