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£20 sterling brexit weakness
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Brexit - How weak could sterling get?

07th July, 2016

The UK electorate’s decision to vote for Brexit has sent shock waves through currency markets, and evoked dark memories of sterling crises in the past. At the time of writing the pound is at its lowest level against the US dollar since before the Plaza Accord was signed in 1985 – its lowest level in three decades.

 

Sterling has gone from one crisis to another

The fear is that Brexit could open the pound to speculative attacks similar to the Exchange Rate Mechanism (ERM) crisis in 1992. In a historical context sterling has fallen much further in the past. As shown in Figure 1, the pound has been in crisis mode at least once a decade for the last 40 years, and fell as much as 57% during the early 1980s against the dollar.

From the peak of $1.59 (GBP/USD) last year, the pound has fallen below $1.30, a drop of around 20%. When we extend the peak back to July 2014 when it hit $1.72 against the dollar, then it is down 25%. Using this as the starting point puts the pound on a similar depreciation to when the UK crashed out of the ERM in 1992.

 

Bank of England (BoE) lends its support

Although the pound remains one of the world’s reserve currencies making up 11% of the International Monetary Fund (IMF) special drawing rights (SDR), it is very difficult to defend your currency as central banks in Switzerland and China have found out recently. Governor of the BoE Mark Carney was quick to offer £250 billion of liquidity should conditions warrant, which has helped steady the ship. Of course the BoE learnt this lesson in the run up to the ERM crisis in 1992 when it was unable to keep the currency above its agreed lower limit against the deutsche mark.

Note: The Plaza Accord of 1985 allowed for active depreciation of the dollar against all major currencies including the pound.

 

Twin deficits do not bode well

From a fundamental perspective, dark clouds were gathering for sterling even before Brexit. Combined, the UK’s fiscal and budget deficits are around 10% of Gross Domestic Product (GDP) – or roughly 5% each based on 2015 figures. This is high relative to history and well above other developed nations. History has shown that the currencies of nations with large current and fiscal deficits can be prone to bouts of weakness. This is one of the primary reasons Chancellor George Osborne continues to make swingeing cuts to public finances in order to try and balance the books.

The fall has been pretty significant already since the vote but in a historical context depending on how quickly the exit terms are agreed there may be further to go. How much further sterling will fall will depend on negotiations with other European leaders on the terms of the exit and whether the UK can secure some form of favourable deal similar to that of Norway or Switzerland. If such an agreement cannot be reached in a worst case scenario we think sterling could fall to 1.20 against the dollar, and move toward parity against the Euro.

Figure 1: GBP/USD exchange rate, 1971-2016

Source: Bloomberg

1970s

The 1973 oil shock meant price inflation was running at a double-digit rate by the middle of the decade and the economy was suffering from high levels of unemployment and a large budget deficit. As a result, sterling began to weaken by the summer of 1975 which prompted the Wall Street Journal to run an article, “Goodbye, Great Britain”, advising investors to sell the pound.

In 1976, Labour Prime Minister Harold Wilson suddenly resigned and his successor, James Callaghan, took over an economy in serious trouble. Fearing a speculative currency attack, Callaghan turned to the IMF for a £2.3 billion bailout. At the time, it was the highest amount ever requested. In return for the assistance, the IMF insisted on cuts in public expenditure to reduce the budget deficit. This resulted in a shift in policy to targeting inflation and expenditure rather than focusing on full employment. The result for sterling was a 40% drop in its value against the dollar between March 1973 and September 1976.

1980s

The ‘Winter of Discontent’ in 1978 proved to be the death knell for the Labour government. The economy was still in dire straits and the government had introduced pay caps which resulted in widespread trade union strikes. In 1979 the Conservative Party, led by Margaret Thatcher, swept into power. By that time sterling had regained all of its losses against the dollar. The discovery of North Sea oil meant Britain was now an oil-producing nation and net exports benefited from a higher oil price. Thatcher faced a difficult start with continued trade union disputes, including the coal miners’ strikes, coupled with the Falklands War. But it was a turning point for sterling as exchange controls were lifted. Sterling’s weakness against the dollar continued right up until the signing of the Plaza Accord in 1985 when the G5 nations, including Britain, agreed to devalue the dollar. In the four years between 1981 and 1985, sterling lost over half its value against the dollar, falling from $2.40 to as low as $1.05.

1990s

In 1990, the UK joined the European Union ERM which was an attempt to link European currencies and eventually pave the way for the creation of the euro. The ERM set bands within which each European currency had to stay. Each member’s central bank had to intervene in the domestic market to make sure its currency remained in its band. From the outset, the pound struggled to keep inside its 6% band against the deutsche mark at DM2.95 and the UK government had to intervene to support it. The onset of the UK recession in the early 1990s prompted speculators, including George Soros, to put increasing pressure on sterling by correctly assessing that the pound would have to devalue. In 1992, in an attempt to prevent a run on sterling, the UK Chancellor Norman Lamont increased interest rates to 12% and then again to 15% (the second hike was later rescinded). However, this failed to stem the tide and on 16th September (known as Black Wednesday), Prime Minister John Major was forced to announce that Britain would leave the ERM to prevent the UK losing billions trying to support the currency. From March 1992 to February 1993, sterling fell 29% against the dollar.

2008/9

The most recent devaluation of sterling occurred during the global financial crisis in 2008. Having reached a pre-recession high of $2.10 and €1.50, sterling fell to a low of just 1.35 against the dollar and just above parity with the euro in late 2008/early 2009. As banks including Lloyds and Royal Bank of Scotland failed, the currency lost over one-third of its value. The drop triggered talks of a repeat of the 1976 crisis and fears that the IMF would have to be called in again. Confronted with falling house prices and a collapse of the banking system, a number of attempts were made to support the economy. Bank of England Governor Mervyn King slashed interest rates to just 0.5%, the lowest level in the Bank’s 300-year history. He also launched a £375 billion quantitative easing programme. These measures pushed the value of sterling lower against most major currencies which improved Britain’s competitiveness and helped the economy recover from the worst recession since the 1930s.

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