Will the pound eventually fall below parity with the dollar and euro? There is a good reason to think it will, and the reason isn’t Brexit.
How much further will the pound fall?
We don’t tend to have sterling crises these days: sure the pound falls sharply from time to time, but the media doesn’t seem to care. The last time we had a proper, bona fide crisis with the pound was in 1992, when it was ejected from the European Exchange Rate Mechanism, the forerunner of the euro. Back then, protecting the pound was seen as vital to keep inflation in check, and to try and stop the pound sinking and sinking, the then chancellor Norman Lamont, put interest rates up to 15 per cent, before bowing to the inevitable.
These days, the Bank of England sets interest rates, not the chancellor, inflation is about as scary as a sedated guinea pig, and holiday makers seem to be the only ones that care if the pound falls.
Except of course, back before the general election that ended Gordon Brown’s time in Downing Street, those on the right wing of the Tory Party used to talk about the risks of a crash in sterling in much the same tones that they might have used if the four horsemen of the apocalypse were riding amongst us. It’s odd, because those same people now seem to think a falling pound is good.
Let’s look at some of those things that are not very popular with politicians or indeed some of the media that report on them, and that is facts.
After 2008, the pound fell sharply, from 1.50 or so euros in early 2007 to within a wisker of parity in 2009. Against the dollar it dropped from around two dollars to 1.40 dollars over a similar time frame.
It then gradually rose back up, peaking at around 1.70 dollars and 1.40 euros in 2014.
The result of the 2008 crash in the pound was a one-off jump in inflation which was not matched with a corresponding rise in wages. I believe, (so, I deviate from facts) we can date the surge in populism to that period — with falling real wages in part caused by the fall in the pound, and partly caused by automation.
Then, with the Brexit vote, the pound fell again, once again causing real wages to fall.
In recent weeks, with speculation over the arrival of Boris Johnson at number 10, the pound has fallen from a cycle peak of 1.17 euros in May and 1.33 dollars to 1.12 euros and 1.25 dollars.
Will the pound fall further?
I believe it will, and for a reason that builds on one of those pesky facts.
The UK’s balance of payments are in crisis, even though hardly anyone is talking about it.
Despite the falls in the pound post Brexit vote, the balance of trade remains seriously in the red. Our net trade on goods are services is in deficit to the tune of around two per cent of GDP. This is not the worst seen this century, we saw an even bigger deficit to GDP in 2008, but it is the worst this decade.
The overall current account, which includes trade in goods and services, current transfers and investment income is in deficit to around four per cent of GDP. A couple of years ago, the deficit was at the lowest since the Second World War. It has improved mildly in the last couple years, but the word ‘mildly’ is key.
The big concern, however, relates to investment income. Historically, (I mean the last few decades) there has been good and bad news associated with this. The bad news: the value of British owned assets held abroad was less than the value of foreign owned assets held in the UK. But the British owned assets held abroad are typically more risky, which means they tend to pay more income. The good news then is that until recently, the UK’s net income from investment was positive, this limited the size of the overall current account deficit.
2008 saw net income go negative before recovering. But ever since around 2012, net income has been negative.
The deficit in investment income did improve a tad last year, but only because the UK’s economic performance was so lousy that income from assets in the UK flowing abroad was low.
The net income deficit is currently just over one per cent of GDP.
What does this mean?
It means that sterling should fall much further.
Andrew Wishart, UK Economist at Capital Economics said: “The conventional view is that following the referendum the pound has fallen enough, and that if there is a Brexit deal, it is only going to rise. The current account deficit suggests not. And if it widens as we expect, another fall in the pound is on the horizon. Be wary of a rally in sterling based on Brexit. It will only make our fundamental concerns bigger, and is likely to prove the prelude to a sharper move in the other direction sometime in the next five years.”
I would suggest that parity with the dollar and euro within five years is highly likely. This might be good news for FTSE companies that do most of their trading abroad, but bad news for growth in real wages.
If the pound overshoots on the way down, and drops below parity, the Bank of England may feel it has to increase interest rates. This could be the trigger for the next UK recession.
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