International competitiveness

International competitiveness refers to how well a given country performs in terms of either price or non-price competitiveness. While the price of a good or service is an important element for many products international demand may be relatively inelastic for many goods, including heavily branded goods supplied by global multinationals, hence non-price factors may provide more clues as to changes in competitiveness levels.

Discovering the causes of poor competitiveness, and putting policies into place to improve competitiveness is important for a trading economy.

Price competitiveness

Price competitiveness can be assessed in several ways, including:

Relative export prices

In terms of price competitiveness, the price of exports of one country relative to those of competitor countries plays a key role in determining how well a country can sell their goods and services abroad.

Export prices, in turn, are affected by a range of factors, including relative inflation rates.

Relative labour costs

Average, or unit, labour costs are another indicator of competitiveness, given that labour costs can contribute significantly to the overall price of exports. The higher the labour costs, per unit of output, the lower the level of competitiveness.

Labour costs are affected by several factors, including wage levels, non-wage costs such as worker's insurance and contribution of businesses to pensions, and benefits such as maternity or paternity leave.

Productivity levels also affect labour costs per unit, with improvements in productivity and the use of new technology reducing labour costs.

The relative exchange rate

Changes in relative exchange rates also have an impact on price competitiveness. However, there are different ways to measure the exchange rate.

Nominal rates refer to the exchange rate unadjusted for inflation, and real exchange rates refer to the nominal rate adjusted by taking inflation into account.

Hence, if we are looking to compare the real exchange rate between two countries - say the USA and UK - we need information on prices changes in the USA and UK as well as the exchange rate. Consider the following hypothetical example.

Nominal exchange rate £/$ Price index for UK Price Index for USA
2019 1.29 100 100
2020 1.32 104 102
2021 1.25 108 104

For 2021, the nominal rate of exchange for £1 against the $US has fallen from £1=$1.32 to £1=$1.25. (Which is a 5.30% fall).

However, inflation over the same period has differed in each country, with the price index for the UK rising more rapidly than for the USA. The nominal exchange rate must be adjusted by the relative inflation rate in the UK, which is found by multiplying the nominal value of £ in 2021 (which is $1.25) by ratio of prices (which is 108/104), which give a real exchange rate of £1.29.

Hence, when inflation is taken into account, the real fall in the value of the £ (from 1.32 to 1.29) is only 2.27% compared with the nominal fall of 5.30%.

While looking a tourist rates (bi-lateral rates) may be useful in terms of assessing the rate of exchange between two currencies, such as the $US and the £GB, an exchange rate index provides a better means of tracking changes over time.

Using an index to assess the effective exchange rate

Matters are more complex when trying to assess how well a currency is performing against a basket of other relevant countries. One currency could have appreciated against one other currency, but appreciated against others, in which case an index can be used to find an 'average'.

However, the average must be weighted according to how important other currencies are in terms of the currency under consideration. For example, consider a country with the following currencies, and the proportion of trade with other countries.

In the following hypothetical example, country A trades with 4 other countries:

  1 2 3
% of trade with A Index of real currency change Weighted index (1 x 2)
B 40 108 4320
C 30 105 3150
D 15 100 1500
E 15 90 1350
  This provides 100 weights   10320/100 = 103.2
Hence, when trade is taken into account, the index can be 'trade weighted'. The weights are then removed by division once they have done their job.

Here, the trade weighted index is 103.2 for country A's currency against 4 major trading partners or competitors, meaning that, 'on average' the currency appreciated by 3.2% over the period considered. In terms of competitiveness, the overall assessment would be that country A was now less competitive.

Factors worsening price competitiveness

  1. A high relative inflation rate

  2. As mentioned, if a country suffers price inflation, especially from cost-push causes, relative to its trading competitors then it will find it increasingly difficult to compete. This is one reason why countries have similar targets for desirable inflation rates. If all trading partners set inflation rates of 2% as their monetary policy target, then over time no country will reduce its competitiveness - at least in terms of inflation.

  3. An over-valued currency

  4. If a currency is 'over' valued - in other words at a rate which leads to a worsening of the current account (other things being equal) - goods for export become expensive relative to competitors. This was the fate befalling the US and UK during the fixed exchange rate system between 1944 and 1971, with an over-valued UD dollar and UK pound making it increasingly difficult to export - in comparison with, arguably, an 'under-valued' Japanese Yen, and German Deutschmark (which preceded the Euro). When the IMF system finally collapsed, currencies began to move towards equilibrium, with US dollar and UK pound falling relative to the Yen and Deutschmark.

    While in the floating exchange rate era the problem of over-valued currencies is reduced, countries that more aggressively managed their exchange rates - such as China - can maintain their currencies at a level which 'artificially' improves their competitiveness.

  5. Poor labour productivity levels

  6. We have already noted that poor labour productivity can increase relative unit costs, but it needs a special mention here, given that, for some economies, there is an appreciable productivity gap between themselves and their competitors - notably, the UK.

Productivity can be measured in two basic ways.

Productivity can be measured as the value of output per worker, or the value of output per hour worked.

The simplest way to calculate output per worker is to divide nominal GDP by the labour force.

Factors affecting labour productivity

  1. The level of labour skills relative to firm's requirements

  2. Education in digital skills and digital literacy

  3. The application of new technology to the production process

  4. The flexibility of labour in being able to respond and adapt to changing needs

  5. The level of regulation of labour - excessive regulation can cause distortions and inefficiencies

  6. Management practices which can impact on job design and the efficient use of labour

Failings in productivity levels are likely to be the result of a combination of factors. It should be noted that economies dominated by services are likely to find it more difficult to improve productivity levels given the low level of application of new technology to services, compared with the application of technology to manufacturing.

To some extent, it is predictable that productivity growth in industrialised economies will eventually slow down. This is because of the underlying problem of diminishing returns to capital investment.

Trends in productivity - selected OECD countries

The general trend in productivity - in terms of GDP per hour worked - is upwards, with average growth since 2015 (the base year) across the OECD countries of around 1% per year.

Factors worsening non-price competitiveness

No-price competitiveness relates to factors other than price, and could worsen as a result of:

  1. Poor product design in comparison with competitor countries.
  2. Low product quality, including unreliability and poorly constructed products.

Poor marketing, where products are not advertised effectively, or where customer needs are not understood.

The significance of competitiveness

Improvements in competitiveness are likely to lead to a range of benefits to an economy, including the following macroeconomic benefits:

  1. Increased exports which increase aggregate demand leading to job creation and greater economic growth.
  2. Improvements in a country's balance of payments.
  3. Downward pressure on prices as goods and services are produced more efficiently.
  4. From a microeconomic perspective, firms can gain in terms of:

  5. Increased export revenue.
  6. Increased market share of domestic firms.
  7. Increased profits.

Policies to improve competitiveness

Policies need to address the underlying causes of poor competitiveness, including domestic inflation, and poor labour productivity.

In terms of controlling inflation, tight control of the money supply (monetary policy) along with prudent government spending (fiscal policy) will provide a low inflation environments.

However, perhaps the most appropriate long term solution to competitiveness issues it to implement various supply-side initiatives, including:

  1. Investment in education and training to upgrade knowledge and skills, especially in terms of relevant IT skills.
  2. Encourage inward migration to close any skills gap.
  3. Tax incentives to encourage firms to reinvest profits into new technology or other capital expenditure.
  4. Improvements in infrastructure which enables goods to be produced and distributed at lower cost.
  5. Privatisation of state-controlled enterprises to enable them to compete in free markets.
  6. Deregulation of previously regulated industries to enable new firms to enter the market.

Analysis of policies

In terms of demand-side policy, including tighter monetary and fiscal policy, there are likely to be conflicts between achieving increased competitiveness and other objectives.

For example, policies to prevent inflation can dampened down growth, and cause job losses.

Higher interest rates can also deter capital investment, which itself would worsen competitiveness in the long run.

On the supply-side, most of the individual policies identified are expensive to design and implement, and are likely to take a long time to have any effect. For example, investment in education may take a decade to have an effect.

More specifically, while improving infrastructure is expensive and provides benefits in the long term, the short term effect may be increased disruption and considerable pollution.

Privatisation may result in falling wages for employees and a loss of job security, and may simply convert state owned natural monopolies to privately owned ones, with no efficiency gains.

Finally, encouraging inward migration may create issues regarding the pressure of increased demand for housing, education and healthcare.