Why British Pound Will Remain Weak Over Short Term & Even Weaker in Long Run
18:03 GMT 26.09.2022 (Updated: 15:21 GMT 28.05.2023)
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The pound sterling fell almost 5% to a record low against the US dollar on September 26. On Friday, the British currency also saw a dramatic slide falling more than 3.5% against the greenback. What does this turbulence mean for the British economy and Liz Truss' cabinet?
The exchange rate of the British pound has sharply dropped for three major reasons, according to Sergio Rossi, professor of macroeconomics and monetary economics at the University of Fribourg, Switzerland.
"First, in the UK, the still ongoing sharp increase in consumer prices induces a correspondingly strong reduction of households’ purchasing power, hence also a reduction of firms’ business and profits," explained the professor. "Secondly, the US Federal Reserve has recently increased its own policy rate of interest, thereby making the US dollar a more interesting asset to invest into across the foreign-exchange markets. Thirdly, the newly-elected UK government’s economic policy announcements in favor of the most wealthy people are going to hit this country’s economy negatively."
The aforementioned elements have prompted a number of actors across the global financial markets to sell British pounds in order to purchase US dollars or a variety of US-dollar-denominated financial assets, according to the academic. As a result, the pound has ended up depreciating.
It's not the first time this month that the British pound has plummeted against the US dollar. On September 1, sterling fell to around $1.15. On September 7, the British currency reached $1.1406 which was the lowest level since 1985. Another dramatic slump – to less than $1.10 – occurred on September 23, after Britain's new Chancellor Kwasi Kwarteng unveiled his bold "mini-budget." Finally, in early Asia-Pacific trade on September 26, sterling nosedived to $1.0327 (before it regained some ground to about $1.05).
"In my view, the British pound will remain weak over the short run, and could even be weaker over the long run, in light of the economic policy stance of the new government and its likely negative consequences across the British economy over the long run," commented Rossi.
At the same time, the still enduring energy crisis – which is unlikely to end before long – could further aggravate the weakness of the pound across the foreign-exchange markets because of the dramatic increase in energy costs, according to him.
"For a number of small and medium sized firms in the UK, this weakness of the pound, and the related higher import prices, will much reduce their profits, hence also the employment level across the country," the professor explained. "As a result, the British middle class will suffer more, both on the labor market, where real wages and employment will fall, and on the market for produced goods and services, where a number of prices will continue to increase. This situation will aggravate the social conflict across the UK, which might put the British government at stake, hence the risk for PM Truss to be dismissed in a not too distant future."
26 September 2022, 06:02 GMT
Chancellor Kwarteng's Mini-Budget Hit Sterling
Meanwhile, a bold rescue plan announced by UK Chancellor of the Exchequer Kwasi Kwarteng last week is unlikely to save the day for the British currency. Instead, the Truss cabinet's mini-budget could dump the sterling further, according to Marc Ostwald, chief economist at ADM Investor Services International.
"The big shock was basically that it just meant more and more borrowing," Ostwald said. "So borrow and spend and hope largely that growth will actually pick up as much, so as to not really create a long-term problem. But the markets doubted that, and it's not really very surprising, particularly, I think one of the really negative aspects was the Office for Budget Responsibility was not asked to provide a corresponding report, regardless of whether it's correct or not; one which basically outlined what the costs and the benefits were likely to be for the economy in the short to medium term."
Kwarteng's plan would cost more than £411 billion ($446 billion) in extra borrowing over five years, according to Resolution Foundation estimates. For their part, the Institute for Fiscal Studies (IFS) and Citibank projected that tax cuts would increase Britain’s public debt-to-GDP ratio from a little over 80% in 2021-2022 to nearly 95% in 2026-2027.
"Where the new government seems to be misunderstanding financial markets is that you cannot just spend your way out of trouble," Ostwald highlighted. "There are comparisons being made to what Thatcher did. But what Thatcher did was much more controlled, far more controlled, and it was much more clearly laid out. This still seems to be really just ripping up the rulebook for the sake of ripping up the rule book and turning around to people, 'well, why do you think I can't do that'? Which is not really quite good enough."
24 September 2022, 13:06 GMT
Are BoE and Treasury Really in the Same Boat?
Another issue puzzling investors is an apparent lack of coordination between the British government and the Bank of England (BoE) with the former stepping up borrowing and the latter increasing borrowing costs. Reuters forecast on September 15 that BoE and the Treasury risk "policy clash" as the British central bank is trying to tame inflation while Kwarteng's strategy could stoke prices even further.
"If the Bank of England's tightening policy in conjunction and in a sense where the government on the fiscal side with loose fiscal policy and the Bank of England with tighter monetary policy are acting in a coordinated way, which they definitely don't appear to be, there's quite a lot of little barbs going forwards, backwards and forwards, above all, from the government to the Bank of England," says Ostwald.
Following the Monday pound slump, Andrew Bailey, the governor of the Bank of England, announced that the Bank "will not hesitate" to change interest rates as needed.
"As the Monetary Policy Committee (MPC) has made clear, it will make a full assessment at its next scheduled meeting of the impact on demand and inflation from the Government’s announcements, and the fall in sterling, and act accordingly. The MPC will not hesitate to change interest rates as necessary to return inflation to the 2% target sustainably in the medium term, in line with its remit."
It doesn't create a good impression if the BoE and Treasury's work is not coordinated, noted Ostwald, forecasting that the "sterling is going to be under something of a cloud."
