There could be a sustained decline in Sterling of 10 to 20 per centby George Magnus / June 9, 2016 / Leave a comment
With two weeks to go until the EU referendum and opinion polls bouncing around either side of a very close outcome, a new focus is forming—at least in global financial markets—on Sterling. Soon, it may become a more ubiquitous totem as people become anxious about the outcome of the referendum itself, and start to see its impact on the currency as a weathervane for what lies ahead for the economy.
Angst about Sterling is hardly surprising. Most economists, and the credible UK and global institutions that have opined on the economics of Brexit, think that a vote to leave will result in a meaningful—and perhaps sustained—decline in Sterling, perhaps of the order of 10-20 per cent. Why would this happen, and how much would it matter if it did?
To counter the concern that “Remainers” have about a slump in Sterling, “Leavers” refer, completely out of context, to the European Exchange Rate Mechanism (ERM) debacle in 1992—commonly known as Black Wednesday.
After that episode, the effective trade-weighted value of Sterling fell by 20 per cent between 1992-96. The economic impact of this devaluation proved to be quite benign—it helped the economy to emerge from the 1991-92 global recession while interest rates fell sharply. Between 1996-98, Sterling recouped its previous losses and more. It bears mentioning that the 1990s were the start of a two-decade period of buoyant global growth and world trade. Emerging markets, not least China, were starting to have a major impact on the global economy, and the information and communication technology revolution featured prominently, as did higher productivity growth.
The next few years, and even 2016, are set to be very different. There are many reasons for this, and I and others have examined them in Prospect before. But here are five reasons why Sterling might be particularly vulnerable now and in the coming years.
Firstly, Brexit will usher in an extended period of economic unpredictability, which will restrain spending, lending and investing. Secondly, the UK’s star performance for economic growth in the OECD will be snuffed out, perhaps by a new recession, but in any event by stagnant investment and growth. Thirdly, to the extent that the UK’s trading arrangements with Europe will be overturned, the external deficit, which is already a huge five percent of GDP, makes us vulnerable to additional deterioration and exposes us to the risk of inadequate capital inflows with which to finance it.
Fourthly, reflecting all the preceding issues, risk premiums in UK financial assets, especially equity markets and corporate bond markets, as well as Sterling, should rise. Higher risk premiums are, roughly speaking, the counterpart to lower prices, meaning that asset values would decline. Gilt yields, though, may fall but for bad reasons, that is, they would reflect a flight to safety and an aversion to riskier assets. Finally, Sterling may be additionally vulnerable against the US dollar because US interest rates may yet go up this summer, or from the second half of 2016. This would boost the US dollar, though it has to be said that this is all subject to the possible impact of a Trump presidency on US asset values.
By way of background, a 20 per cent fall in Sterling would take the rate against the US dollar down to $1.15-1.20, which is still some way off the low point reached in 1985, when there was parity between the two. If it fell the same against the Euro, it would be back to where the Euro-Sterling rate was at the birth of the Euro in 1999. Everything we import would rise in price, and foreign travel would be dearer. Against this some of our exporters could do well—if they could take market share in stagnant trade conditions—and UK property would become more attractive to foreigners.
It should be noted, though, that dyed-in-the-wool “Leavers” see things differently. Consider what John Redwood, Tory Eurosceptic, leading “Leave” campaigner and chief global strategist for an investment management company, has recently said. Writing on the Financial Times’ website, he notes: “As the chances of the UK leaving have increased, long-term UK interest rates have continued to fall, while Sterling has rallied a bit from the lows against the US dollar in February.”
This is a curious interpretation, and reflects political sentiment rather than anything else. UK gilt yields have declined and there has been a renewed fall in US Treasury yields as higher US interest rate expectations have evaporated again, and also against a backdrop of weaker UK economic performance in recent weeks. It had nothing to do with the referendum or Brexit opinion polls. Similarly, Sterling has fallen with every opinion poll showing a tilt towards “Leave,” and vice versa with respect to “Remain.”
This week, there was some concern about a Sky News report that the UK had experienced unprecedented capital outflows in March and April. This is something we should indeed worry about if the UK did vote to leave. But the fact that Sterling has been essentially trendless, although slightly more volatile, suggests that the term “capital flight” is a misnomer at the moment. In fact what Sky News referred to was a Bank of England monetary report that showed an extraordinarily large increase in foreign currency liabilities in March, but this was not so much UK residents shifting their deposits in UK banks abroad, as corporations hedging against the risk of Sterling depreciation in the month after the Prime Minister announced the date of the referendum.
This brings us to the final thing about which we can only speculate: the legal aspects of a post-Brexit negotiation. This is fun to ponder, but if it happened, messy wouldn’t even begin to describe it.
Strictly speaking, the result of the referendum is not binding under the terms of the EU Referendum Act 2015. Further, the Prime Minister, whoever it is, is not legally bound to send so-called Article 50 notifications to other EU members to trigger exit negotiations. We can all opine about the likelihood of these things happening or otherwise.
Assuming the government does send an Article 50 notification, a sovereign Parliament would still have a number of tasks to perform once the Conservative Party’s leadership issue had been resolved, a process that might take a few months. For example, Parliament would have to pass an Act to revoke the European Communities Act 1972. This could prove to be contentious in a Parliament which it is believed has a 70 per cent majority for staying in the EU, or at least staying in the Single Market. Equally, it could also be a new Act designed to define the UK’s new relationship and arrangements with Europe. “Leave” has not defined what such arrangements might look like, and it would be up to Parliament to decide how to frame them. A preference for a Single Market arrangement is quite likely, and would also have to be agreed by other EU and possibly European Economic Area members.
These deliberations would doubtless be bound up with the precise arithmetic of the vote, as well as the wishes of Scotland, Northern Ireland and Wales. The bottom line is that a Brexit vote in the referendum might prove devilishly difficult, even impossible, to honour in the manner in which “Leave” campaigners articulated to voters. We can imagine charges of betrayal, a constitutional crisis, calls for new elections which the Fixed Term Parliaments Act forbids, save for a two-thirds majority in the House of Commons.
I have skirted over complex and perhaps unpredictable legal issues and outcomes here. But imagine something like this happening, as the economy faltered, and capital started to haemorrhage out of the country. Then that 20 per cent fall in Sterling I alluded to earlier might start to look rather optimistic.