Why is the pound falling in value and does it matter?

Sterling in freefall; the pound takes a battering; Britain’s currency in a nosedive – the media are full of headlines about the abrupt depreciation in the value of the pound sterling in the global foreign exchange markets.

Sterling’s trade weighted price has dipped to its lowest level since October 1996. And the suddenness and severity of the depreciation has taken economists back to September 1992 when the pound made an unceremonious departure from the European exchange rate mechanism.

The pound is down by more than 20 per cent against the US dollar since the autumn of last year. From £1 buying $2.11 last year the spot exchange rate is currently closer to £1=$1.60 with currency traders looking at $1.50 as the next psychologically important benchmark.

I was asked by a student the other day how it could be that the Yen and the US dollar are both appreciating at a time when official policy interest rates in both Japan and the United States are much lower than in the UK and the Euro Zone?

My answer was a guarded one since many factors come into play when driving the value of a currency higher or lower. But in a word – expectations!

Room to cut

In Japan where official interest rates are 0.5% and in the USA where the Fed has rates at 2.5% much of the scope for relaxing monetary policy by cutting nominal interest rates has been taken away. After all, the floor for policy rates is zero.

But in the UK a different story is emerging. The Governor of the Bank of England, Mervyn King, made an important speech in Leeds a couple of days ago in which he confirmed that the UK economy was entering a recession and that the extent of the downturn was difficult to forecast.

This seems to have spooked traders in financial markets.

When the currency dealing floors opened for business the morning after his speech, sterling came under immediate selling pressure with traders convinced that the Monetary Policy Committee will cut interest rates aggressively over the coming months.

They are at 4.5% at present – but what are the odds that base rate will dip to 3% or 2% within a year – taking nominal interest rates to their lowest level in the Bank of England’s long history?

Thus the foreign exchange market has been “pricing in” extensive cuts in UK interest rates which has the effects of making sterling less attractive to inflows of foreign currency – otherwise known as hot money.

The currency markets also seem to be worried about the general weakness of the British economy amid fears that recession will be deeper here than in other advanced G7 nations. This is in part due to our dependence on financial services and also the falls in the price of residential and commercial property.

Currency dealers may also be deterred from buying sterling because of worries about the scale of the twin deficits – namely the government’s fiscal deficit and also the imbalance in trade. Britain’s trade deficit will reach record proportions in 2008 and over the medium term our currency remains over-valued.

Searching for a safe haven

In contrast, both the Yen and the US dollar have been handed the baton of being a ‘safe haven currency’ – an accolade that sterling held for sometime after the end of the dot com boom around the turn of the decade.

Hedge funds (most of which are funded within the USA) and other investors are busy unwinding their long positions in commodity markets (where prices are falling) and in emerging market countries (where growth is slowing) – they are doing this by buying up dollars and sending them home.

So the fall in sterling is the result of a change in market sentiment about the health of the economy together with the fall-out from the banking crisis and a flight towards assets and currencies that will better hold their value during difficult times.

The demand for sterling assets has fallen and the supply of sterling on the market has risen – result – the pound falls against most currencies – notably the Euro and the US dollar.

So what does this mean for the British economy the day before a recession is announced!

It is interesting that the current depreciation comes just as the economy is entering the early phases of a downturn. Head back to the autumn of 1992 and the devaluation came at a later stage of the cycle with the UK struggling to emerge from a slump.

In theory a lower pound will provide a boost to aggregate demand. As a rough rule of thumb, a 4 per cent depreciation of the exchange rate has a similar effect on aggregate demand as a 1 per cent reduction in interest rates.

So can the weaker pound do a useful job for Mervyn King and Alastair Darling?

As always, the answer is unclear.

A cheaper pound is good news for manufacturing exporters who can now target overseas markets knowing that they can sell at a more competitive price. Much will depend on how quickly they can take advantage of this opportunity – do they have enough spare capacity? Can they raise the extra finance to invest in export promotion?

The fear is that any benefit from a weaker currency will be offset by weakening demand in key export markets – as real incomes fall and demand tails away, even a sharply lower pound may not be sufficient to fill the export order books.

The depreciation in sterling is good news for the UK tourist industry and it may also prompt a further outflow of migrant workers from the UK taking a little pressure off the unemployment numbers in the near term.

But import prices will rise hitting retailers and businesses who must import essential raw materials and component parts.

It may be that the link between a lower pound and higher inflation is less relevant as the UK economy descends into a recession, after all one of the features of an downturn is a marked reduction in the pricing power of businesses throughout the economy.

But the Governor Mervyn King will be casting a nervous look at the foreign exchange markets in the days and weeks ahead. An unstable currency will do little for fragile business confidence.