The fall of the pound

Last week’s flash crash, in which the value of sterling fell by 6 per cent in moments before rebounding, has refocused the public’s attention on the pound. But concentrating on a few minutes of drama in the early hours of the Asian markets misses the bigger picture, that of a steady slide in the value of our currency—one driven by politics.

The vote to leave the European Union took the financial markets by surprise and sterling fell by around 10 per cent in the week afterwards. After a few months of stability at a lower level it started dropping again in late September at a speed that picked up as the Conservative Party conference rolled on. The markets had been telling themselves that the political elite would go for a soft Brexit, retaining membership of the single market, and that not much would really change. Over the past few weeks, government rhetoric has forced the realisation that we are heading for a hard-edged exit. The last four days have been the worst for the pound's value since June.

A few days ago, investment bank Morgan Stanley advised clients that “Political commentary is the most important factor for GBP right now... Over the weekend we will be watching for comments in the Sunday political news shows and related press stories.” In effect, the markets have gone from monitoring the short-term economic indicators to watching The Andrew Marr Show to guess the direction of the pound.

The issue is that big and important questions about the future of our economy are now being driven by politics. The Treasury’s pre-referendum arguments are still often dismissed as part of “Project Fear” but among economists there is near universal acceptance that leaving the single market (even if, in the politicians' weasel word, we retain “access” to it) will lead to slower UK growth in the coming decade. What we have seen in the markets over the past couple of weeks is the likelihood of that outcome being priced into our currency.

It is often stated that a floating currency, like the pound, acts as shock absorber for an economy. That is certainly true but it cannot absorb the whole shock. If you crash riding a bicycle it is better to be wearing a cycling helmet—but better still to avoid the crash in the first place. The fall in the pound’s value—it is now down around 15 per cent against a broad basket of other currencies—will raise the price of imported goods, adding to inflation and squeezing real incomes. While the most visible manifestations of this are in high-value items like the new iPhone, the price of food and fuel will drift up too.

The silver lining is that the fall should help make our exports more competitive. That said, this is far from automatic and the process is a long-term one. The increasing complexity of cross-border supply chains has complicated the picture—it is now cheaper to buy a British-assembled car abroad, but the components are often imported from elsewhere. In addition, as we learned after sterling’s last large deprecation in 2008 and 2009, many of the things we export (like high-value services) are not especially price sensitive. Overseas companies, for example, are unlikely to boost demand for English lawyers just because the bill will be 15 per cent lower.

In the medium-term a cheaper currency should help us narrow our trade deficit (we import more goods and services than we export) with the rest of the world. But, to be clear, trade deficit rebalancing is more likely to be driven by weaker imports than stronger exports. In other words, it is the hit to living standards that results from the ability to buy less stuff that tends to bring an economy back into balance. That process is unlikely to be pleasant.

That though may be the benign scenario. The UK current account—a measure of our broad financial position with the rest of the world—had a deficit of 5.4 per cent of national income in 2015. Our trade deficit and the fact that foreign investors currently earn more in Britain than British investors earn overseas is funded by a flow of foreign capital into our economy.

The real worry now—one that hopefully will not be realised—is that the process of Brexit, the diminishing of our long-term growth prospects and much of the anti-foreign rhetoric that has been unleashed will start to deter foreign capital. The UK is seen as an international safe haven: a secure place to store overseas assets. This status has both boosted UK asset prices and led to lower UK borrowing costs—the loss of it would reverse both. Lower asset prices and higher borrowing costs are pretty much the exact opposite of what the economy currently needs. For all the excitement in the foreign exchange market over the last week, the slow drift north in government borrowing costs may be more significant in the medium term.

Falling sterling brings much short-term pain and, hopefully, some long-term gain. How far it falls will be determined by our economic prospects, but these long-term prospects are currently in the hands of politicians deciding our future trade policy. Investors will be watching The Andrew Marr Show for a while longer.