Will the pound crash, stumble or simply fall a bit?

Posted: July 12, 2013 in Currencies, UK Economy, UK Exports, United Kingdom
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The pound fell to a three year low against the dollar this week. At the time of writing there are 1.4949 dollars to the pound, and many have hit the panic button. They say a crash in sterling is in sight. Are they right?

The current dollar pound exchange rate is low, but it’s far from being a record. It was lower in 2009, and in the mid-1980s went close to parity with the dollar. There are two reasons to fear for sterling, and indeed the consequences of a fall in the pound. But there are reasons for less pessimism, indeed even optimism too.

Reason number one is the Fed. If good news on the US economy continues it has said it will start cutting back on its quantitative easing programme this year, halt it altogether next year, and up interest rates in 2015. If this is indeed how it pans out, as US rates rise, money might well flow into the US from the rest of the world. Many central banks may respond by upping rates.

Because of the high level of household debt we can’t really afford higher interest rates in the UK. The Bank of England may have to choose between upping rates to stop a rout on sterling, but creating massive hardship for households with high debts in the process, or just accept a much cheaper pound relative to the dollar. Just bear in mind, however, that this problem is not unique to the UK, and if rates rise in the US, the pound may fall relative to the dollar, but stay firm relative to other currencies, such as the euro.

Reason number two is more serious. In the UK we are used to imports of goods and services being greater than exports, but at least income from investments flowing into the UK tends to be greater than income flowing abroad. But there are signs that this is changing. The UK’s net investment income has been negative in three out of the last four quarters. The story here is complicated.

The value of investments held by foreigners but relating to the UK is much greater than British investments abroad. But UK investments held abroad tend to be higher risk, and generally provide a much higher return; there are signs this is changing, however, and that is a worrying development.

To be clear, if net investment income continues to be negative this will put pressure on sterling relative to most foreign currencies, not just the dollar. On the other hand, a cheap pound may be good for exporters, although it will be bad for inflation, and may extend the period of time in which wage increases lag behind inflation.
But this may not occur, not at all.

Take the latest trade data. In the latest three months the value of exports to China was 17 per cent per cent higher than the average 2012 quarterly level. Import values from China were little changed, so the trade deficit with China, which had averaged £5.2 billion a quarter in 2012 shrank to £4.8 billion in the last three months.

Historically, the UK runs a trade in goods surplus with the United States. That rose in the latest three months. The value of exports was 5 per cent higher than its average 2012 level, while imports fell by 8 per cent. In the three months to the end of May, exports to non-EU countries increased by £1.7 billion while imports increased by £0.9 billion.

There is another reason for optimism, there signs that the UK is on the march to recovery. See: UK recovery: the reasons why and why not 

There is one big danger however. The UK does suffer from a disease. For too long money has flowed into supporting the housing market – though not house building – but there are few signs this is changing.

Remember, the strength of sterling tends to tell us how strong the economy is. If the economy does well sterling usually rises. In a way, the value of the pound is like the UK’s share price.

Right now, company cash holdings sit at around 20 per cent of GDP or at a 25 year high. If this money is used to fund investment, then the UK may boom. If instead, companies hoard their cash, banks focus on parking cash sitting in deposit accounts in mortgages, and the government focuses on trying to get house prices rather than investment up, the UK’s share price – or if you prefer to put it these terms, the value of the pound – will come under new and prolonged pressure.

© Investment & Business News 2013

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