A Record Low Pound Sterling: An Early Response to the UK Government’s Recent “Fiscal Event”
Soon after Chancellor of the Exchequer Kwasi Kwarteng introduced his tax-cutting “Growth Plan” on 23 September 2022, pound sterling plunged to its lowest level against the US dollar since decimalisation in 1971. The currency markets, less than reassured, then delivered their verdict on a “fiscal event” that combined massive, at best partly-funded, tax cuts to the tune of £45 billion with similarly lavish increased government borrowing to fund an Energy Price Guarantee for families and businesses. The pound fell by 4.9 per cent to a low of $1.0327 on the Asian markets during the morning of 26 September, approaching the dollar in parity, before rising later in the day to around $1.07- representing the proverbial last straw on the camel’s back- just as sterling also fell against every other major currency in the world. Earlier in the year, currency strategists at the Bank of America, Goldman Sachs, and Deutsche Bank had already commented upon the vulnerability of pound sterling, as it was beginning to take on “emerging market characteristics”.
Since the breakdown of the Bretton Woods system of pegged exchange rates between 1968 and 1973, floating exchange rates have taken over from fixed exchange rates. In a floating exchange rate system, the price of a particular currency is determined by the balance of its supply and demand in foreign exchange (forex) markets, theoretically allowing for self-correction. With fixed exchange rates currency price is pegged to that of another stable currency or, historically, to the price of gold (gold standard)
Currency depreciation is a feature of a floating exchange rates, referring to the fall in the exchange value of one unit of a currency, the quote currency, in relation to that of one unit of another currency (or basket of currencies), the baseline currency. This is not a measure of the intrinsic value of the currency in question. Over the longer-term, relative differences in currency prices between countries reflect differences in economic productivity, money supply (including the effects of quantitative easing), interest rates, and rates of inflation. Shorter-term swings in prices can result from political uncertainty, macroeconomic shocks caused by pandemics, wars, and the like, or from currency speculation.
Exchange rates influence cross-border economic transactions, including trade in goods and services, capital flows, and the tourist trade. Currency depreciation makes exported products cheaper, while foreign goods and services cost more. As the volume of exports increases and domestic producers step in to substitute for costlier imports, employment and productivity may rise and the current account deficit, as measured in the nation’s balance of payments account, is accordingly reduced. The domestic tourist industry may be boosted by foreign visitors lured by lower prices, while holidays abroad become more expensive. But it’s all a matter of striking the right balance. Reduced competition may undermine the efficiency of domestic manufacturers. The need for costlier imported raw materials, components, equipment, and machinery could also increase the price of some exported goods dependent on their use, making their continued manufacture uneconomical. Pricier imports of food, clothing, energy (oil, gas), and capital goods, can all contribute to higher inflation, accompanied by falling standards of living and the stifling of economic growth, especially important since the UK is a net importer of goods. Consequently, exchange rates have at times even been manipulated by governments, during so-called “currency wars”, to enhance their foreign trade competitiveness by adjusting the prices of traded goods. But such planned currency depreciations can only encourage retaliation, defeating their intended purpose.
Abrupt and unplanned currency depreciation, as is the case in UK at present, can harm the economy in ways other than those listed above. The yield, or interest payments, on government bonds (gilts) rises, thereby increasing the returns to investors and also the cost of government borrowing. Risk-averse foreign investors may be tempted to divest themselves of their sterling-denominated portfolio assets, such as bonds, equities, and mutual funds. On the other hand, canny speculators, such as hedge fund managers, can benefit from taking short positions on the pound, with suggestions that such trading may have already taken place.
Central banks and national governments may have to step in to reset the economy when currencies depreciate, by increasing interest rates, which attracts investors, and by selling their foreign currency reserves in forex markets. It is hoped by many that the Bank of England will schedule an emergency meeting, to raise interest rates and halt the decline of sterling, or maybe, much less likely, that the government will apply the brakes on its accelerating tax-cutting programme and re-evaluate the ongoing “market moves”.
The UK government has taken a bold gamble and delivered a coup de grace. Many predictions of the outcome are now forthcoming, from economists and politicians of different persuasions, with a variety of takes on the situation. From the comfort of an armchair, all one can do is watch helplessly and hope that some good may come out of it after all.
Ashis Banerjee
PS: The downward slide of the pound was halted, and then reversed, following the Bank of England’s emergency intervention on 28 September. The central bank assigned £65 billion from its reserves towards a time-limited and targeted programme to buy predominantly long-dated (dated over 20 years) UK government bonds (gilts) at daily auctions, over 13 working days, until 14 October. The Bank of England delayed its plans for quantitative tightening, or selling off its holdings of gilts, in favour of stabilising, and restoring investors’ confidence, in the bonds market. A major priority was to prevent insolvencies in pension funds that rely heavily on gilts and employ derivatives-linked liability-driven investment strategies to fund defined benefit, or final salary, pension schemes, but had suddenly fallen vulnerable to cash demands from banks seeking to minimise their losses. Other forms of corrective fiscal and monetary interventions may yet be necessary in the days and weeks to come.