15 August 2019

Sterling crisis? What crisis?

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The slide in the pound to multi-year lows against both the dollar and euro has prompted talk of ‘meltdown’ and ‘free fall’. Some commentators are already calling this a ‘sterling crisis’, and speculating about what Tory politicians would be saying if it were happening under a Labour government. Even the normally sensible Conservative MP, Sam Gyimah, has described the ‘plummeting pound’ as ‘catastrophic’. Frankly, this is a load of baloney.

For a start, let’s try to keep a sense of perspective. Headline writers love a ‘new low’. But the level of the pound relative to where it happened to have been many years ago is far less important than the rate of change over shorter periods. It is this rate of change that determines the impact on inflation and other potential side effects, including the risk of a wider market panic.

For example, after the June 2016 vote to leave the EU, the pound fell as much as 20% (on the Bank of England’s trade-weighted index) compared to a year earlier. The higher cost of imports drove consumer price inflation to a peak of around 3% in 2017. That was clearly a bad thing.

More recently, though, the decline in the pound has been much smaller – around 5% – even though it has set some new multi-year lows along the way. Correspondingly, the inflationary impulse will be much smaller too. There has been no panic in other markets either. This is not, yet, a crisis.

Of course, the weakness in sterling largely reflects concerns about the risks of a disorderly Brexit and the pound therefore could, and probably would, weaken further if the UK does indeed leave the EU without a deal. Nonetheless, four factors should limit the downside.

First, the large decline since 2015 means that the pound is already looking cheap again. The OECD and IMF’s estimates of the ‘purchasing power parity’ rate against the dollar, and the Peterson Institute estimate of the ‘fundamental equilibrium exchange rate’, average out at around $1.40, or 20 cents higher than the current market rate of around $1.20.

Second, leaving without a deal would no longer be such a surprise. The latest bookmakers’ odds put the chances at more than 40%, and speculators are already running hefty short positions against the pound. To a large extent, then, No Deal is priced in.

Third, the additional contingency planning now being undertaken means that the UK and the EU should be better prepared than they were in March. That means even if the markets are still underestimating the probability of No Deal, this should be at least partly offset by a smaller hit to the UK economy.

Finally, of course, all currency movements are relative. The euro itself is looking shaky. Indeed, Brexit timing effects may have been decisive in causing German GDP to contract in the second quarter too. Even if the short-term disruption to the UK economy is proportionately greater, the euro area will suffer as well. Investors are also starting to lose faith in the US.

Consistent with this, even those forecasters with a relatively negative view of the economic impact of No Deal do not seem to expect a collapse in the pound. I’ve heard some academic economists talk of another 30-40% decline. However, the median No Deal forecast in a recent Bloomberg survey of actual market professionals was $1.10. This would be a level last seen in 1985, but still less than 10% below today’s level. Any fall against the euro would presumably be smaller.

So when might a sterling correction become a ‘sterling crisis’, similar to those that the UK has seen before? In my view, a ‘sterling crisis’ is when the pound itself becomes the problem, rather than a symptom of other economic pressures (and part of the solution to them). This might come about, for example, because a disorderly run on the pound prompts the Bank of England to raise interest rates to defend the currency and keep inflation down. A 30% slump might be a game changer here, but a 10% fall would almost certainly not.

What’s more, sterling crises usually come about because the level of the currency is too high to begin with. The 1992 crisis in particular was eventually turned into an opportunity by letting the pound find its own level outside the ERM. It is not so long ago that the big auto manufacturers were arguing that we had to join the euro to get the pound down and save the UK car industry. Many sensible people, such as the businessman John Mills, are still arguing that sterling needs to drop a lot further to rebalance the economy.

I’m not so sure of this myself. A further fall in the pound would have costs. The immediate impact would be negative, as the prices of imports rise before the volumes of either imports or exports have a chance to adjust (the so-called ‘J-curve’ effect). This was, of course, what happened in 2016/17. But this isn’t the whole story either. Over time, an increasing proportion of any additional costs can be avoided by switching from imports to domestic production.

The boost to exports will increase over time as well. Some economists have argued that this boost will be much smaller than in the past, because a larger share of the value added in exports now comes from components that are themselves imported. But the latest OECD data still put the share of domestic value added in UK exports of goods and services at nearly 85%.

It has also been suggested that the global downturn and trade wars will limit the upside for exports.  But even if export volumes do not rise, and UK exporters are unable to gain market share, they will still benefit from the increased value of overseas sales when translated back into sterling.

Admittedly, as others have argued, Brexit uncertainty may mean that firms are wary of investing more in increased capacity to take advantage of a weaker pound. But if so, this delay should only be temporary.

Indeed, there is already evidence that UK businesses are feeling more optimistic about the future and that this is due, in part, to the more competitive currency. For example, the July services PMI reported that ‘a number of survey respondents commented on improved sales to clients in external markets, helped by the weak sterling exchange rate against the euro and US dollar. Moreover, the latest survey indicated the fastest increase in new work from abroad since June 2018.’

And in the July manufacturing PMI, ‘manufacturers maintained a positive outlook in July. Over 46% expect output to be higher in one year’s time, compared to less than 10% forecasting contraction. Optimism was linked to new product launches, an expected rebound in export sales, strong order pipelines, reduced uncertainty following Brexit and improved infrastructure (including 5G networks)’.

In summary, this is not a sterling crisis. A further fall in the value of the pound is, of course, possible and would push up inflation, but probably not by much as in 2016/17. It should also be temporary, if the fears about No Deal prove to be exaggerated. In the meantime, the costs could be offset by measures such as a temporary cut in VAT and increases in welfare payments to the most vulnerable. And if sterling does remain weak, let’s not forget that a more competitive currency has significant economic benefits too.

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Julian Jessop is an independent economist