A British one pound coin sits in this arranged photograph taken in London, UK
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LONDON – The exchange rate of the British pound against the US dollar has been on a rollercoaster ride for the past few months.
After a year of steady decline, it plunged to an all-time low below $1.10 in late September following the UK government’s infamous “mini-budget”. It then recovered to $1.16 after the country swapped its finances and prime ministers in late October; and fell to $1.11 after the Bank of England downplayed rate hike expectations and warned that Britain had entered its longest-ever recession as early as November 3rd.
The recent highs and lows have all taken place in a range where sterling has not traded against the greenback since 1984. In mid-2007, on the brink of the financial crisis, it was possible to get two dollars for a pound. In April 2015 it was still worth $1.5; and $1.3 in early 2022.
Almost all currencies have fallen against the dollar this year and sterling’s depreciation against the euro has not been as severe given the European Union’s own challenges in terms of economic slowdown and energy supplies.
But the euro is still much stronger against the pound than it was in the 1990s and for most of the 2000s; and the global importance of the pound has evaporated since the days when it was the world’s reserve currency in the early 20th century.
A historically weaker pound on a medium to long-term basis has a variety of implications for the wider UK, economists told CNBC.
The most basic is that imports become more expensive while exports theoretically become more competitive.
“The problem is that Britain is very import-dependent, almost two-thirds of its food is imported, so a 10 percent fall in the real effective exchange rate translates quickly into higher food prices,” said Mark Blyth, professor of economics and public affairs at Brown University.
“Britain is a low-wage economy. This will hurt.”
long-term situation
Richard Portes, an economics professor at London Business School, also pointed to the UK’s reliance on foreign trade, meaning a “significant” impact on prices from a weaker currency, although he said there was no evidence of a significant impact on prices yet British demand for foreign goods – but neither for exports, which are theoretically becoming more competitive.
He also noted that currency devaluation had a level effect on prices rather than inflation.
“It’s a one-time effect. It doesn’t necessarily give us inflation in the sense of a continuous rise in the price level,” he said. “If it contributes to a wage-price spiral, then that’s inflationary and that’s what we’re all worried about now. I don’t want to see wage increases that trigger price hikes and a spiral.
Sterling’s depreciation has been a long-term trend since it was allowed to float freely in 1971, he told CNBC: “I think it’s reasonable to expect that to continue. And that’s partly because productivity, and therefore competitiveness, hasn’t been very good in comparison to our trading partners. So that is the long-term situation.”
The UK’s current account deficit (where a country imports more goods and services than it exports and is £32.5 billion for the UK) is funded by capital inflows, he noted. Former Bank of England Governor Mark Carney said Britain depends on the “kindness of strangers”. But Portes said: “It’s not their friendliness, it’s them who want to invest because they find their prognosis and possible returns. Investors find British assets sufficiently attractive to bring in capital.”
“If they find it less attractive, UK assets would depreciate to encourage people to invest more, so the exchange rate will continue to fall. That depends on confidence in the UK economy, fiscal policy and all of that stuff.”
But, Portes said, the weaker pound per se is not an issue for the fiscal plan the government is currently conducting, with a much-anticipated budget due on November 17.
“If much of our debt was denominated in foreign currency, it would be, but it isn’t. Our national debt is almost entirely denominated in sterling. And unlike some countries, we don’t see that as a problem. I don’t think write-downs that we’ve seen or are likely to have in the next few years will have a big impact on the fiscal position.
“Growth model is dead”
Blyth says the higher prices caused by a weaker currency will have a deeper and longer-lasting impact beyond budget pain.
“The UK is a heavily consumption-based economy and such a shift is tantamount to an excise tax. That means less fuel for the economic engine. The UK already has low growth and even lower productivity growth.”
Potential upside for exports has been wiped out by Brexit, he said, noting that the UK economy has shrunk from 90% to 70% the size of Germany since the 2016 vote.
“What does that mean in the long term? It means the old British growth model is dead,” Blyth continued.
“Financing one’s own consumption from other people’s savings (capital imports) and exchanging overpriced houses had an expiration date. It’s over. The combination of a structural decline in the exchange rate and positive inflation ends it.”
The appeal of cheap UK assets only exists if they are revalued, he said, and “GBP is not the USD. Point.”
Adjusting to this new reality will be painful but necessary in the long term, Blyth believes.
“A Britain not dependent on Greater London generating 34% of GDP, with subsistence transfers north and west, is a better Britain. It will only take time, imagination and investment to get there.”