Sterling takes a pounding

Among the most important economic landmarks of the last 70 years were Ramsay MacDonald’s decision to take Britain off the gold standard in 1931, Clem Atlee’s and Harold Wilson’s devaluations of 1949 and 1967, respectively, Ted Heath’s floating of the pound in 1972, and John Major’s entry into the ERM in 1990 and humiliating exit in 1992. Over the last decade, however, sterling has moved off centre stage as government policy focused more on the inflation rate than the exchange rate.

Sterling has once more recaptured the economic limelight. In June, the Chancellor delivered his verdict on the Treasury’s Five Tests. He concluded the time was not yet right for the UK to join the single currency. Brown’s decision not to recommend a referendum took place against the sharpest currency movements since this government came to office in 1997. Sterling appreciated against the dollar but has weakened against the euro to the point where, in old deutschmark terms, one pound is worth DM2.72 – its lowest rate for six years.

The weakening dollar was attributable to concerns over the strength of activity in the US. But the appreciation of the euro occurred when forecasts of growth in the eurozone were being revised downwards and with Germany, in particular, flirting with recession. Not the typical environment in which a currency appreciates.

As ever, the condition of the US economy dictates events globally. Disappointing returns from US investments and a slowdown in growth signalled a weakening of the dollar. The fact that US authorities are now facing a fiscal deficit as well as a balance of payments deficit makes the country’s problems more long term and suggests that the dollar’s slide is not a short-term shift before a robust bounce-back.

The brunt of the dollar’s decline has fallen on the euro. While its trade-weighted value slipped against all major currencies by some 17% in the first six months of this year, it fell by a quarter against the euro.

Higher interest rates in Europe were a factor as the Federal Reserve cut US rates to stimulate domestic activity. In addition, it seems European investors, who played a prominent part in the dollar’s rise, are no longer prepared to fund the US’s huge account deficit. With no obvious alternative to replace the dollar, European money has stayed in Europe.

Sterling, like the euro, has gained against the dollar (by about 15% between January and June this year) and for the same reasons. The UK economy has been holding up relatively well during the global turbulence and, if US growth continues to disappoint, the dollar decline may have a little further to run. The present rate ($1.60/$1.70 against the pound) is familiar territory. It is where sterling spent most of the three-year period between 1997-1999.

Harder to explain is the fact that sterling dropped below the January 1999 euro launch price of 70.6p for the first time in early May this year.

The UK’s small but persistent current account deficit is one reason. There are also now more uncertainties about the short-term outlook for the economy, particularly with the housing market and consumer debt. The fragile markets for equities and bonds have made the UK more reliant on short-term funds, which, in turn, makes sterling more vulnerable.

Because the US and UK economies have much in common, particularly external deficits and high levels of indebtedness, it is natural that their currencies should have moved in line against the euro. Similarly, the bearish views on the dollar suggest the pound could go even lower against the euro.

The Chancellor discussed a possible rate of 85p against the euro but concluded a rate nearer 73p would be reasonable. Compared with 12 months ago, this is good for British exporters and bad for inflation. Since eurozone authorities are unlikely to view the sustained undermining of their export prospects with equanimity, this favourable UK rate might not last.

A combination of factors accounts for sterling’s fall against the euro, among which is the fact that currency markets always overshoot, going up too high when sterling rises and down too low when it falls. So, when one euro was worth 60p, it exaggerated the strength of the UK economy relative to the eurozone, but today’s rate of 70p flatters it. Where it goes from here is hard to call. Few economists observe the old adage that when discussing exchange rates, always give a rate and always give a date, but never both at the same time. Perhaps to say that sterling’s rate against the euro is likely to change is about as much as can be predicted with any certainty.