A year ago, Sterling was still worth €1.15. On holiday in Italy these last two weeks, I was aware that my pounds were buying fewer and fewer Euros by the day, and my latest credit card statement shows transactions including handling fees, such that the effective rate I was paying was about €1.05. At one airport on Saturday, I saw the currency exchange rate lit up on a screen at 1:1. A number of currency analysts have lowered their predictions, for what they’re worth, to suggest that the market rate will be parity by the end of the year, meaning that commercial transactions will take place where £1 is worth less than €1. Sterling may be holding its own against a weak US dollar that few analysts expected at the start of the year, but it’s been trashed against the Euro. And still, the Brexit protagonists say this is good news. Is it?
In textbook economics, a weaker exchange rate should boost a country’s competitiveness, making exports cheaper to foreign buyers, and imports more expensive to local consumers and businesses. This should lead to an improvement in the balance of trade and payments, and help to stimulate economic growth. This is what the handful of Brexit-supporting economists insist is truth. Yet the facts speak otherwise.
We should not make the rookie error of conflating the depreciation of Sterling currently with the slump in the value of the currency when the UK came out of the Exchange Rate Mechanism in 1992. Remember that at that time, Sterling had been struggling to remain glued to the Deutschemark, necessitating tight economic policies, especially double digit interest rates. Once the UK government abandoned the idea of the peg (a fixed rate against the Deutschemark), economic liberation truly arrived, with interest rates more than halving over the following two years to just over 5 per cent. This was not so much a currency devaluation as a financial and economic regime change, and the UK benefitted significantly. This is not happening today.
“Sterling’s slump reflects fundamental changes in the UK’s economic prospects—and is likely to continue”The balance of payments deficit has fallen from over 5 per cent of GDP in 2015 to about 3.5 per cent of GDP in the first months of 2017, but this has not really had a positive impact on UK economic growth, bearing in mind other things going on in the economy. In fact, the UK’s economic growth rate has been sliding down the EU league, while countries such as Spain, Portugal and France, not to mention Germany, have been enjoying something of a purple patch of growth even as the Euro has been strengthening. This contrast looks likely to continue for the foreseeable future.
There’s no question that a weaker Sterling is pushing up import prices, and therefore consumer prices and the cost of living. At a time when wages are stagnating at low levels, in spite of apparent full employment, this is squeezing living standards and subtracting from economic growth. The efficient export companies that are making competitiveness gains and increasing their sales don’t even come close to offsetting this ubiquitous effect. Provided Sterling stops falling at some point in the future, incomes will no longer suffer from rising import costs pressures, but that point could still be some time off.
If Sterling’s fall and the rebalancing of exports and imports were the only thing that mattered, we could probably bite our bottom lip, accept the one-off hit to real incomes and living standards, and move on. However, there are more sinister forces at work that suggest that Sterling’s slump reflects more fundamental and corrosive changes in the UK’s economic prospects and is likely to continue.
The principal problem is that far from helping to liberate the UK, Brexit will undermine the country’s capacity to participate effectively in the wealthiest free trade area in the world and in the corporate supply chains that help to make it so. By leaving the single market and the customs union, even after the short transition the government seems to now favour for the latter, UK companies will be at a competitive disadvantage. Disruption to trade flows and investment activity will raise costs for UK producers, and since companies that specialise in traded goods generally enjoy higher productivity growth than those that don’t, the UK economy will experience weaker growth and higher economic costs—regardless of any new trade agreements with far away countries in a relatively limited number of goods and services.
“Currency markets hate uncertainty, and UK politics is delivering uncertainty in spades”At the same time, even if the current account deficit remained at 3.5 per cent of GDP or so, the deterioration in the economic outlook may mean that foreign investors, who supply the capital flows to finance this deficit, could still get cold feet. If we had to reduce the deficit still further in order to secure stable funding, the cost to the economy and to jobs could be greater still.
Quite what Labour’s shift on Brexit, reported over the weekend to include continued membership of the single market and customs union during a transition period, means is unclear (though it is still welcome). We don’t know if that shift simply defers Brexit for a year or two, or is political cover for something totally different. Neither do we know how the government’s position might change if the mood in parliament changes as a result of the Labour shift.
It’s a cliche but also a fundamental proposition that currency markets hate uncertainty, and UK politics is delivering uncertainty in spades. The proverbial clock on Brexit negotiations is ticking away with a de facto time limit of this time next year, and a general election by next summer is an ever present possibility. There’s no reason for Sterling to stop falling yet, and for its deleterious consequences to unsettle and unhinge the economy.
