Will sterling’s slide spook investors?

Hamish McRae has a thoughtful piece in his column in the Independent on the risk that sterling’s fall will make it harder for the UK government to finance their budget deficit. It is a good example of how, in the current climate, the effects of monetary policy and fiscal policy decisions are becoming blurred.

The depreciation of sterling over the last year is a large one. My chart shows the effective trade-weighted sterling index which tracks not just the pound against the Euro or US dollar but its value against a basket of currencies and the scale of the drop is stunning.

A lower external value of the currency ought to be an important part of the jigsaw in rebalancing the British economy. In particular, allowing for the inevitable time lags, it should lead to a stronger export performance and a switching of domestic spending away from (more expensive) imports towards home-produced goods and services.

Put another way, a 20 per cent plus fall in the currency is the equivalent of a sizeable reduction in domestic interest rates in terms of the net impact on aggregate demand (C+I+G+X-M). This is important given that the Bank of England is fast running out of room to cut their own policy interest rates any more!

But there are dangers and risks.

First the possible impact on inflation since the prices of many raw materials, components and energy imports will rise. This is perhaps less of a problem when the domestic economy is heading into a steep recession.

Secondly the danger that a weak currency and the risks associated with investing in sterling-denominated assets will make it difficult for the government to find overseas borrowers willing to buy the new issues of debt to finance a rising budget deficit.

This will increase the cost of funding a deficit and the danger is that government borrowing will “crowd out” the market for loanable funds and make life even harder for businesses wanting to borrow to finance their own expansion plans. The public sector can squeeze the life out of the private sector.

The counter argument is that the government can simply tell the central bank (in our case the Bank of England) to finance the budget deficit through the issue of short term debt (bills) rather than longer term securities (bonds) and then use open market operations (including quantitative easing) to boost the money supply and keep short term interest rates low. This might stoke up some inflationary pressures down the line, but it would avoid the risks of a UK budget deficit of 8 per cent or more of GDP causing long term interest rates to rise thereby making borrowing more expensive for the corporate sector.

I am fairly relaxed about the recent downward spiral in sterling - our currency has been overvalued for some time and sterling’s fall could prove to be a significant weapon in the battle to limit the damage of this recession. But when the government is borrowing such huge sums, we must keep an eye on the risks that the international investment community decides en masse that the UK economy is no longer a favoured venue for inflows of capital. That could drive the pound even lower.

Hamish’s article is here: