©Yui Mok/PA Archive/PA Images
If you’re going to Egypt or Turkey for your holiday this year, count yourself special. These are about the only major countries whose currencies have fallen against Sterling since last year’s Brexit referendum. The good news, such as it is, is that since the heavy fall in Sterling last summer things have calmed down. It has traded relatively quietly against the US dollar in a band of about $1.20-1.27, and fluctuated against the Euro in a range of roughly €1.14-1.17.
But as the timetable for, and content of, negotiations between the UK and the EU27 become clearer, Sterling’s sensitivity is likely to again come to the fore. If recent speculation about the prime minister’s willingness to compromise and accept an orderly Brexit via a lengthy transition arrangement were to prove right, Sterling might not behave too badly. It could even rise a bit. In the case of a hard Brexit, however, there could be real trouble.
Remember how Sterling plunged after last year’s referendum? Brexiteers, including a handful of economists, maintained that there was no reason for concern. They argued that Sterling had been overvalued before and that, by becoming more competitive, it would deliver a positive shock to the economy much as it did after tumbling out of the Exchange Rate Mechanism (ERM) in 1992.
This analogy does not quite hold, though, and there is a more relevant way to think about Sterling’s performance. Its recent plunge happened for a specific reason: the referendum result (if not Brexit, which hasn’t actually happened yet). Brexiteers claim that the UK balance of payments deficit, which ran at over 5 per cent of GDP until very recently, would have called for depreciation at some stage. This is true, but there were no signs that financing the deficit was a problem before June 2016. We also know that Sterling’s behaviour in the run-up to the referendum was correlated positively and strongly with opinion poll sentiment.
Further, we must not overlook the fact that Sterling’s 28 per cent fall against the US dollar has been one of the biggest since the collapse of the Bretton Woods system in 1972. Then, it fell by 37 per cent. From then until the referendum, there were then three major Sterling slumps, each punctuated by periods of appreciation, albeit on a long-term downtrend. The all-time low of $1.037 was reached at the end of the biggest decline in 1980-85 (55 per cent), coinciding with a particularly robust US dollar and a collapse in oil prices at a time when North Sea oil was much more significant in the UK economy. There were smaller but still highly significant falls in 1992-93 (27 per cent) after Sterling fell out of the ERM, and in 2007-09 (31 per cent) during the financial crisis and recession.
Sterling’s shorter history against the Euro, introduced in 1999, basically features a period of strength until the financial crisis, a slump from €1.49 to €1.04 between 2007-09, a rise back to €1.41 through the Euro-crisis until mid-2015, and then another slump after the referendum.
So what are the consequences of its most recent fall? One of the first has been a rise in inflation. With the level of import prices rising by nearly 11 per cent at an annual rate from July 2016 to February 2017, consumer price inflation has risen from -0.1 per cent in the year to July to 2.3 per cent in 2017. So far. It is widely expected to rise to 2.8 per cent by early 2018, with a chance that it could rise past 3 per cent. Since wage and salary formation has remained pretty stable, the consequent squeeze in real incomes for households is going to lead to weaker spending and economic growth. We can see this already in the retail sales volume data, which fell 1.4 per cent in the three months to the December 2016—February 2017 period. Unless wages and salaries pick up significantly, we should expect rising inflation to act as a drag on the economy. This is partly what the fall in Sterling has been telling us: that is, that the outlook for the domestic economy was poised to deteriorate.
Normally, though, a sharp fall in Sterling would boost exporters, whose profits and investment would then expand. Indeed, this is precisely the positive shock that has characterised past devaluations and depreciations, especially when they coincided with relatively buoyant global economic conditions. With world trade and the global economy looking a little brighter than was feared a few months ago, Sterling could then be on the cusp of rising again.
The pattern of the fall in Sterling since the referendum, however, may be telling us that something isn’t normal. In other words, that exporters, unusually, will face tougher and more costly times ahead because leaving the EU will entail adjustment to a world of new tariffs and non-tariff barriers, and weaker investment and productivity, unmitigated for now by any other government policies at home. For reasons I have examined here recently , the UK’s trade prospects are nowhere as rosy as is sometimes made out, and unlikely in any event to compensate for leaving the EU.
This drop in Sterling, therefore, is unique, and reflects a trio of risks. First, weaker growth in domestic demand as a result of rising inflation, and then as a result of weaker supply-side growth as Brexit happens. Second, a more complicated and costly trade environment for exporters, which means that the traditionally expected export-led stimulus after a big depreciation may not happen, or may not happen as expected. Third, the referendum may well have embedded a risk premium in Sterling reflecting uncertainty about how the UK’s large current account deficit would be financed smoothly by capital inflows. A lower currency should help to allay concerns here, but at some cost to UK consumers and living standards regardless.
None of this is to say that Sterling will go on falling. Its decline since the referendum may have sufficed to address all three risks. If the government manages to negotiate a soft Brexit with reasonable conditions and a long enough transition period, we might even find a change in sentiment pushing Sterling back up again. Ultimately though, Sterling’s fate rests on three things, only one of which we have had to deal with before, namely whether the external deficit shrinks enough to sustain inflows of foreign capital and confidence. The other two—how large the costs to the economy from Brexit actually turn out to be, and the extent to which the government mitigates them—are uncharted and unknowable to even the best traders.
