Will pound be equal to the euro? It’s the cheapest it’s been in 168 years

Oct 24, 2016 9:34 AM|Conotoxia.com

The pound lost more than 15% against the majority of the global currencies since the announcement of the Brexit referendum results. However, this might not be the end of the pound’s problems. It’s possible that the British currency’s worth may equal the euro. A comment from Marcin Lipka, Cinkciarz.pl senior analyst.

Marcin Lipka, główny analityk Cinkciarz.pl

It has been four months since the result of the Brexit referendum was announced. Since then, Brexit has been the main catalyst of changes regarding the pound (GBP). This is mostly a result of a specific structure of the British trade exchange. The unfavorable situation of the pound is also intensified by a danger of secessionist movements, as well as a mild monetary policy.

A portion of Brexit-related dangers are already included in the pound’s exchange rate. According to the calculations from the Bank of England (BoE), its value against the currencies of the countries which are included in the United Kingdom’s trade exchange, went down by 16% since the Brexit referendum. Its value is also the lowest since 1990. Moreover, The Financial Times estimated that the pound is the cheapest in 168 years. So, what else has to happen to increase this decline?

Will a weak pound improve the current account?

The data from the Office of National Statistics (ONS) shows that in 2015, the United Kingdom experienced a trade account deficit at the level of 126 billion pounds (6.9% of the GDP). Between January and August 2016, the deficit was at the level of 88 billion pounds, which indicates that the record level from last year will be exceeded.

In the long-term, a weak pound should improve the trade exchange balance due to a higher competitiveness of British products abroad. However, the deficit scale is large (411 billion pounds for import and 285 billion pounds for export) and basically includes every basic category of consumerism, as well as of investment goods. Therefore, this process may be very long.

Additionally, the import of raw materials or of necessary semi-finished products will automatically become more expensive, due to an increasingly expensive pound. As a result, this may even deteriorate the trade exchange balance in the first few quarters.

However, the United Kingdom finds the services balance more significant. Its result is at positive 4.8% of the GDP. More than 50% of this positive balance is determined by the financial and insurance sector. There is also a positive contribution of transport, telecommunications, legal services, consulting services, engineering and education.

Theoretically, a weaker pound should also increase the surplus of the services balance. However, access to the EU services market may become significantly limited due to Brexit. Moreover, estimated restrictions regarding immigration may cause the most valuable employees of the above mentioned sectors to begin to ignore British cities and choose different locations within the European Union. As a result, the regulation element may appear to be stronger than the higher competitiveness that is related to the pound’s decline. Therefore, the services balance would eventually deteriorate.

It’s also not said that the other components of the current account (primary income balance and secondary income balance), which are at the level of negative 3.3% GDP, would improve. Some foreign investors may decrease the level of their profit re-investments in the United Kingdom, which would limit a positive effect of the lack of necessity to contribute to the EU budget.

As a result, the current account, which was at the level of negative 5.9% GDP in the second quarter (negative 5.4% in the entire 2015), doesn’t need to improve due to the 15% decline of the pound. Moreover, this should cause the pressure on the pound to grow. Therefore, a further overvaluing of the British currency would be required. It would limit import drastically, as well as make export increasingly attractive. As a result, the external imbalance would finally start to decrease.

Internal politics

The majority of the above mentioned processes are also impacted by political matters. Theresa May’s government will have the final word whether Brexit will be mild or hard. The latter option is more likely for the time being. The announcements from the current administration show that immigration control is more significant than the access to the EU market on the current rules.

Long-term negotiations regarding new trade contracts, as well as the risk of deterioration of the conditions for service companies in the European Union, are not the only problems for Theresa May. Representatives of the Scottish National Party have been speaking of the necessity of another independence referendum. This is a result of the fact that Scots voted in favor of the status quo in the Brexit referendum (62% vs 38%). The real risk of the United Kingdom breakdown is another significant element for the pound’s evaluation.

Theoretically, we may assume that a weaker pound, as well as the perspective of a worse economic situation, may change the political scene in the United Kingdom. However, we are dealing with a totally opposite situation for the time being. Support for the Conservative Party is growing. The average result of three surveys from October (Ipsos MORI, YouGov/The Times and ICM/The Guardian), shows that the Tories have a 16% advantage over the Labor Party. In the 2015 elections, it was only 6.6%. Therefore, we can assume that Theresa May’s cabinet will continue its current policy.

Central bank’s role

The monetary policy is also significant for the pound. In August, the Bank of England decreased interest rates and increased assets purchases. This is negative for the pound’s exchange rate. Theoretically, an increasing inflation may be the obstacle for further monetary easing. In the previous macroeconomic projections from the Bank of England, it was to reach the level of 2.4% in 2018.

After the pound’s recent depreciation, it’s possible that the average increase in consumer prices will reach the 3% level in the forthcoming quarters. - We are able to tolerate a slightly higher inflation in order to prevent unnecessary unemployment. We have decreased interest rates in order to support the economy – said Mark Carney, the Bank of England chairman.

Even though the current attitude of the Bank of England seems right, this type of policy is not free of risks. If the uncertainty regarding Brexit remains, the companies will limit their investments. This is even taking into consideration the record low financing costs. This will most likely cause a deterioration in the labor market, despite its current positive condition. Moreover, higher inflation will decrease households’ purchasing power. This will have a negative impact on the consumer demand. Therefore, we may reach the moment in which the economy will be near stagflation (stagnation plus inflation).

If this happens, the BoE will stand before a dilemma about whether to fight increasing prices (risk of a further deterioration of the economic condition), or sustain the mild monetary policy (higher prices). The first solution could stop the pound’s depreciation, but it’s unlikely for it to be chosen. On the other hand, the second solution would increase the pound’s overvaluing.

How much further will pound decline?

The International Monetary Fund estimated that the scale of the pound’s overvalue in the case of Brexit, will be within the range of 5-15%. That was before the British referendum. Other research centers and investment banks were making similar forecasts.

However, these expectations are being modified. The Financial Times cited estimations from Goldman Sachs. They assume that the pound may lose 20-40% in comparison to its value from before Brexit. According to this American institution, this is the only level that could cause the current account deficit to reach an acceptable level.

Regardless of these very bold estimations from Goldmans Sachs, there are more arguments in favor of the pound’s further depreciation. Currently, the most important element is the macro data. If there are signals that the economic situation in the United Kingdom is becoming worse, this will be a strong argument in favor of the pound’s overvaluing.

In the scenario in which hard Brexit policy overlaps a weaker business cycle, we may expect the pound to become weaker yet again. The scale of this wear-off could be within the range of approximately 5-10% (in comparison to the current quotations of the basket). This would push the pound to the range of 4.53-4.60 PLN, which is basically the same value as the euro.


Oct 24, 2016 9:34 AM|Conotoxia.com

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