CURRENCY WEAKNESS
From the desk of MD
IN BROAD TERMS the pound has weakened in recent months against both the US dollar and the euro, and remains extremely volatile given fluctuations within financial markets. This, despite data showing that retail sales had been unexpectedly resilient in October.
Whilst the strength of sterling improved after the announcement of the pre-Budget Report by the Treasury on Monday, the biggest single jump seen in the last 7-years, sterling now trades in median terms at $1.47. Since July, when pound sterling traded at more than $2, sterling has lost more than a quarter of its value against the dollar. Investors are alarmed at the weakness of the UK economy. The slowdown has been accompanied by a sharp deceleration in the rate of inflation. Traders are assuming that the Bank of England will continue to cut interest rates as the economy plunges further into recession.
On the face of it, though, there are reasons to welcome the depreciation of sterling. The economy is at serious risk of something much worse than a normal cyclical downturn. With the freezing of credit markets, the collapse of asset prices in both the financial and housing sectors, and confidence among manufacturers at its lowest for 30 years, respectable economists and political commentators are warning of a serious depression on the scale not seen since the 1930s. Against this background, a weaker and dilute pound provides a minor respite.
Although holidaymakers to the U.S. will find their purchasing power suddenly diminished, manufacturers can expect their exports to be more competitive in world markets. The benefit should not be overstated. The global economy is in recession, and there is no possibility that the UK will avoid this through export-led growth. But the customary risk of currency depreciation – a pick-up in inflation as import prices increase, and nominal wages rise in order to keep pace with the cost of living – is largely absent.
The more serious risk for policymakers is that inflation will undershoot the Government’s target and even turn negative. If prices fell for a sustained period, the economic pain would be intense: the inflation-adjusted value of household debt would increase, and consumption would be reined back further. The Government cannot formally welcome a lower value for sterling; but it will regard this outcome as a minor support in stabilising the economy.
UNFORTUNATELY that is not the end of the story. There are serious potential costs to a precipitate decline in the value of the currency. Because of the collapse of consumption in the global economy – and particularly in America – policymakers need to take action in stimulating demand, further.
They can do this as has now been attempted by boosting public spending, cutting taxes and reducing interest rates. The risk of a large fiscal expansion, though, is that investors will take fright at the prospect of wide budget deficits. Globalised financial markets allow governments, businesses and consumers to borrow more efficiently and cheaply; but they also have the potential to destabilise economies that run up large sovereign debt, by exposing them to the demands of foreign investors.
The Government cannot borrow without limit, budgets have to balance. Numerous emerging economies have suffered a collapse of investor confidence when trying to manage competing objectives of stimulating growth through public spending and the exchange rate, and by moderating its debt burden. The UK is a developed economy, but sterling is not a major international reserve currency comparable to the dollar or the euro. Policymakers do not know the point at which currency weakness might escalate into a currency crisis. And the lesson of recent international currency crises is that they easily translate into banking crises.
The Government was right, for example, in how it recapitalised the banks. But the taxpayer’s exposure to the banking sector makes it all the more important that international investors retain confidence in the currency.
© Mark Dowe 2008: all rights protected
The writer is a management accountant by profession, also holding an M.Sc in Geography.
Filed under: Economic, European Union, Financial Markets, World Affairs | Tagged: asset depreciation, Bank of England, Banking, budget deficit, capital flights, consumer spending, currency crisis, currency devaluation, deflation, depression, economic growth, economic recession, economic stability, euro, exports, Financial Markets, fiscal stimulus, foreign investment, global financial crisis, government borrowing, household debt, import prices, inflation, interest rates, investors, market confidence, pound sterling, pre-budget report 2008, psbr, purchasing power of money, recapitalisation, taxation, uk economy, us dollar, wages
