INT_YCORP_Sterling

This article was first published in the October 2016 International edition of Accounting and Business magazine.

The magnitude of sterling’s post-Brexit slide was something that not even most silver-haired financial veterans had witnessed before. The 8% one-day decline against the dollar was the largest since the era of floating exchange rates began in the early 1970s.

For historians of finance, however, there was a grim familiarity to the pound’s sudden slide. ‘Over the past century sterling has been on a downward ladder, with large permanent steps lower,’ says Rui Pedro Esteves, an associate professor of economics at Oxford University. ‘The pound has tracked the nation’s decline from the world’s dominant economy to the humbler position it occupies today.’

The question now is whether the lurch lower in the pound was a one-off event or marks the start of a more prolonged period of depreciation. And will a weaker currency provide a welcome boost to British exports, or simply erode the real value of wages and accentuate the post-referendum decline in growth?

Public enemy number one for sterling could well be the UK’s ominously large current account deficit – a measure of how much the nation is borrowing from the rest of the world to finance its imports and other payments to foreigners. The shortfall of 5.4% of GDP for last year meant that the UK is more reliant on foreign funding than at any time since the 1940s. In the most recent quarters the deficit rose even higher to around 7% of GDP. No large economy in the world has a larger current account imbalance as a share of GDP. Even in absolute terms it is the second biggest globally, behind the US.

‘This is a key source of vulnerability,’ says Marc Chandler, chief currency strategist at Brown Brothers in New York. ‘If foreigners become unwilling to buy British assets – whether stocks, bonds, or fixed assets – at the current price, sterling will need to fall until these become attractive again.’ With a deficit of £32.6bn in the first three months of 2016, the UK needs to find around £500m every working day from overseas.

Deficit division

Economists are divided over how dangerous the deficit is likely to be. Optimists observe that the deficit should narrow smoothly without another disruptive slump in the pound. While the UK suffered a series of current account funding crises throughout the 20th century, the fact that it now has a flexible exchange rate is likely to reduce the trauma from any adjustment. The roughly 10% post-referendum fall in the pound against the dollar should improve the trade balance by making UK exports more competitive overseas and also make imports dearer. In addition, a large part of the current account deficit derives from a deteriorating income balance – meaning that Brits have been getting less from their investments overseas than the country has been paying out to foreigners.

‘This part of the deficit could paradoxically be seen as a reflection of the UK’s recent economic strength, not its weakness,’ says Scott Bowman, a UK strategist at Capital Economics. ‘The relatively strong growth of the UK economy and higher interest rates relative to Europe have meant that foreign investors have done well, while Brits have got poor returns by putting their money in slow-growing eurozone nations.’ The fall in sterling will now boost the domestic value of corporate earnings, dividend and income payments from overseas.

Still, more painful adjustments may also be needed. A slide in sterling after the 2008 financial crisis had less of a positive effect on the trade position than might have been expected. When imports get pricier, it is not always possible to find immediate domestic substitutes. As a result, the bill for foreign goods simply rises and the deficit actually widens. As the real value of wages falls, living standards deteriorate.

Second, a large share of UK exports are high-end, so the level of demand does not rise sharply if the price falls. This is especially the case for financial and legal services, which are two of the UK’s most successful exports. ‘If the price of advice on mergers and acquisitions goes down, it is unlikely that a US multinational company will decide to take over two companies rather than one,’ quips Chandler.

Selling the family silver?

The other side of the balance of payments equation looks even more threatening. A large current account is not so much a problem as long as foreign investors purchase UK assets. ‘While running large deficits may be seen as selling the family silver, they really become an immediate problem if overseas demand for a nation’s assets dries up,’ says Esteves.

Many economists fear that the referendum outcome will make foreign investors less willing to put their cash in the UK. One of the UK’s chief selling points for foreign companies was the combination of more business-friendly regulations and full access to the European single market. In 2014, for example, the UK attracted a net £44bn, making the UK the number-one investment destination for Europe.

Uncertainty could ultimately end up dampening appetite for other UK financial assets, too. The UK’s appeal for fixed-income investors is likely to decline if, as expected, the Bank of England cuts rates to zero and resumes bond buying in order to push down longer term yields. And while foreign companies are reluctant to sell their plant and equipment, investors in stocks and fixed-income instruments can exit the UK far faster.

As Bank of England governor Mark Carney warned ahead of the referendum, the current account deficit makes the UK reliant on the ‘kindness of strangers’. And in ‘febrile’ and ‘volatile’ market conditions, investors may start to demand a higher risk premium for holding UK assets – pushing up the cost of borrowing for all.

The upshot is that sterling may well be resuming its long downward journey, says Esteves. ‘We could see something a bit like Chinese water torture,’ he says. ‘The pound showed some stability after its initial post-Brexit slide. But it could come under heavy pressure again once Britain formally requests an EU exit, as weak economic data filters through, and if the UK’s negotiations with the EU lead to disappointing results.’

A weaker pound will create winners as well as losers. FTSE 100 firms are highly international, deriving only around 20% of revenues from the UK on average, according to JP Morgan. Their earnings in sterling terms will be boosted as foreign profits are translated back into the home currency. This helps explain why the UK’s benchmark stock index rebounded in the month following the referendum outcome. Exporters of more price-sensitive goods may grab a larger share of foreign markets.

Still, currency weakness erodes the global spending power of Brits, whether they are buying imported goods or travelling overseas. Devaluation is also questionable as a strategy for helping business; instead of improving national competitiveness it can lead to lazy management, reducing the need to boost productivity and habituating firms to sporadic sugar-highs from an exchange rate improvement. ‘If this approach worked, Italy and Greece would be economic superpowers, since they used this tactic frequently before joining the euro,’ says Chandler. ‘It merely enabled them to put off much needed economic reforms to boost underlying efficiency.’

More broadly, the exchange rate is a reflection of a nation’s ability to project its economic power around the globe. As such the sliding pound is not a trend Brits should regard with equanimity.

Christopher Fitzgerald and Fernando Florez, journalists