Most economists agree that a sharp drop in the value of the pound was inevitable following the UK’s shock decision to quit the EU. However they remain deeply divided over whether it will be a boon or a hindrance to the economy.
One strain of opinion is that sterling’s slump will be nothing but good news. A weaker pound will support exports, boost trade and spark a manufacturing renaissance. A more downbeat conclusion points to a risk to living standards as higher import costs trigger inflation and a reduction in UK productivity and output as foreign investment dries up. What we know so far is that the pound has been one of the worst performing currencies in the world this year, falling nearly 20 per cent against the dollar since the referendum vote and dropping to a near six-and-a-half year low against the euro. This has already made life more difficult for foreign holidaymakers and pushed up import costs for some businesses.
There have been winners too. Share prices of the UK’s most international firms have been soaring in anticipation of higher repatriated earnings. Foreign shoppers have also been flocking to retailers in London and Northern Ireland to cash in on sterling weakness.
However, what the lower pound means for the overall health of the economy is far from clear. The simple fact is that sometimes a currency depreciation is beneficial and sometimes it isn’t. Sharp devaluations in the past have boosted growth by making British exports more competitive and encouraging UK consumers to switch their spending away from more expensive imports. That is what happened in 1992 after the UK quit the European Exchange Rate Mechanism (ERM). The resulting export boom helped to pull Britain out of recession and eliminate Britain’s current account deficit.
Some economists think that a sharp rise in exports will save the day again. They see a weaker pound helping to rebalance the economy away from financial services as other industries, especially manufacturing, become more competitive and find new export markets.
[color_quote]Unfortunately, an export boom is far from guaranteed. The fall in sterling that followed the global financial crisis did not kickstart export growth. World trade was sluggish, consumer spending weakened and imports continued to rise faster than exports. In the five years starting in 2010 the current account deficit grew from 2.7 to 4.7 per cent of national income.[/color_quote]
Will we see a repeat of 1992 or the depreciation after the financial crisis? It is difficult to say as each depreciation is different, though the world looks very different to when we quit the ERM. In 1992 monetary policy had been kept tight to keep sterling within its exchange-rate bands. Now interest rates are so low that there is little more the Bank of England can do to encourage companies to invest.
Many UK companies are heavily dependent on global supply chains, importing lots of components from other countries, potentially reducing the benefit from currency depreciation. Indeed, UK businesses reliant on imported inputs are likely to find a weaker currency has serious downsides as costs rise.
Inflation is already on the increase. The consumer prices index jumped to 1 percent in September, though the Office for National Statistics says the figures have yet to fully reflect sterling’s steep drop. This has led many economists to forecast inflation climbing to as high as 3.5 percent next year.
A weak pound and rising inflation would usually mean higher interest rates, but all the indications are that the Bank of England will not rush to push up the base rate. Economists believe another cut to 0.1 per cent is not out of the question.
The prospect of rates remaining lower for longer perhaps explains why the Brexit vote has done little to dampen the residential property market. Indeed, sterling’s slump could prove a blessing in prime central London, one of the few areas to witness a slowdown following the increase in stamp duty on the most expensive homes. Knight Frank says the weaker pound has helped to spur interest from overseas buyers, though many are adopting a wait-and see approach until they have greater confidence that the pound has hits its low point.
When that will happen is difficult to predict. Some analysts believe that sterling is now undervalued. Investment bank BNP Paribas argues that the pound should recover above $1.29. By contrast, HSBC has claimed that the currency could drop to $1.10 and Goldman Sachs that it could fall a further 10%.
The problem is that sterling’s movements are currently being driven by political headlines not economic data, making the future difficult to read. [pull_quote]All we can say for sure is that until an exit deal is agreed with the EU it looks as if volatility will be here to stay.[/pull_quote]