Unit 4: Why is sterling on the slide?

According to The Economist, Sterling has had a very choppy history, marked by crises such as 1967, 1976 and 1992. And it is having another rocky period.  Thanks to Guy Tennant at Norwich School for highlighting this article:

In trade weighted terms, the £ Sterling has dropped more than 7% in just two
months, a fall of a magnitude only surpassed once since the MPC assumed
responsibility for setting UK monetary policy in 1997. The pound has behaved more
like a commodity currency (the Aussie or Canadian dollars) even though it is a large
net importer of commodities.

Mark Carney, the governor of the Bank of England, indicated recently that British interest rates were unlikely to rise in the near future. That may have held down Sterling.  But interest rate expectations can't explain these moves.

Are fears of BREXIT responsible?

Recently there’s been a big increase in the focus on the UK's EU referendum – with
some insiders believing that the likelihood that Britain votes to exit the EU has risen
from 30% to 35%. The uncertain outcome has led to a weaker sterling, which reflects reduced demand and increased risk for UK assets. “But current sterling weakness
is probably only a small taste of what would be store for the UK in the unlikely event
of an exit”.

The Economist is against BREXIT, and quotes bank ING, who think the uncertainty of
the vote might lead to a quarter of a point being knocked off this year's GDP growth,
and a further 1.2 points off 2017 GDP if Britain votes to leave. Morgan Stanley's economists write that “We expect the outcome to be a close call. We also think that
a vote to leave the EU would trigger a major and sustained rise in political and economic uncertainty”.

Indeed, Brexit could trigger another Scottish referendum to leave the UK. This
uncertainty would make it less likely that both domestic and foreign companies
would invest in Britain and according to another bank: “if the UK voted to leave, the
risk of an immediate and severe weakening in economic activity would be very high
and we would not rule out a recession. Consumer and business sentiment could
decline sharply, leading to a slowdown in consumption and business investment".

Those in favour of BREXIT will dispute the numbers, arguing that Britain will be
better off without the dead hand of EU regulation, contributions into the EU Budget
and so on. Given all the uncertainties (Norway is outside the EU but has to
contribute to the budget, for example), there can be no definitive answer. Fans of behavioural economics might note that minds on either side are unlikely to
be swayed by these numbers; confirmation bias tends to set in (you only believe
"facts" that chime with your initial opinion).

Axa, the French insurance company, has just come up with a cost of Brexit of
2-7% of GDP, largely down to the effects of reduced investment and consumer
uncertainty. In the long run, the British economy would probably adjust to the
new reality. Open Europe, a think tank, estimated that the shift in UK GDP by
2030 would lie somewhere in the range of minus 1.6% to plus 2.2%.

Of course, one likely reason for depreciation is Britain's current account deficit,
which at 4.5% of GDP, needs foreign capital to finance it. In the absence of
foreign direct investment, that deficit would be harder to finance; hence sterling's
fall.
A fall in the pound could help exporters but that tactic hasn't been working
elsewhere
(nor did it for the UK when the pound last plunged in 2008-09).

Unit 4: Impact of a strong Pound

Really useful article on a topic that comes up lots in Unit 4. It has been an issue for over a year now, so could be the focus of a case study questions.

It would be great to see you in school to discuss this.

Last autumn all the talk was of the impact of a plunging sterling exchange rate and the UK’s struggle to find new export markets. 

According to most observers it was time to ‘rebalance’ the economy towards a more export-lead model of growth. George Osborne, the chancellor of the exchequer, talked of “a Britain carried aloft by the march of the makers”. The plan was for a revival in manufacturing and exports, driven, at least in part, by a weaker pound. Sterling had fallen by 30% during the financial crisis, but since early 2013 the pound has climbed back, appreciating by 10% in trade-weighted terms.

What impact might this have?

The Economist (source of the graph below) takes up the story, arguing that the rise in sterling is partly good news: it reflects the strength of GDP growth in Britain, which is now the strongest in the G8, as well as the expectation that interest rates will rise sooner as a result. Sterling looks like a relatively safe and stable storehouse for foreign cash as emerging markets wobble.

It is also good news for households—in the short term, at least. Following the 2007-08 exchange-rate depreciation, higher import prices pushed up Britain’s inflation rate, which peaked at 5.2% in 2011 (about a quarter of the value of consumer goods and services originates abroad). With sterling now on the up, inflation has declined to 1.6% and may fall further. Households’ increasing spending power ought to boost both consumption and imports.

But a stronger pound increases the costs of British exporters relative to those of their foreign competitors. At first glance, exporters seemed to gain little from sterling’s big depreciation during the crisis: demand for exports and imports have proven to be relatively price inelastic.

But, according to the article, the weakening pound probably prevented an even more disastrous outcome. After all, the financial crisis dealt a colossal blow to the financial-services sector, one of Britain’s biggest export industries. Without the depreciation, Britain’s exporters might have fared much worse. Now that sterling is rising again,British exporters’ share of world trade may well fall even faster.

The current-account deficit—already 5.4% of GDP—is worrying. Higher imports and lower exports will make it worse. It will also become harder to fund the deficit in the practised British manner: by selling houses and firms to foreigners.

The authors conclude that all this will mean that Britain borrows more from the rest of the world. That is not sustainable indefinitely. Large and persistent current-account deficits, financed by debt, have a habit of spawning violent financial crises. To avoid that fate, Britain must rebalance.