The pound fell to a three year low against the dollar last week, and predictions of doom emanated from the UK’s more cynical press. ‘Oil will go,’ they cried, ‘the cost of holidaying abroad will shoot up,’ they moaned, ‘oh woe is us,’ they lamented. There are indeed strong disadvantages to having a cheaper currency. But there are advantages too, and there are reasons to think that the pound may fall a lot further yet – at least relative to the dollar.
There is one thing that Mark Carney, the Bank of England’s new governor, and Haruhiko Kuroda, the newish governor of the Bank of Japan, have a lot in common. Actually they probably have a lot in common but let’s just focus on this one obvious point today. They both seem to be in the process of enacting policies to weaken their respective currencies. In Japan where the governor has been in his post for a few months longer, the policy is advanced; in the UK it is only really being hinted at.
But recently Mark Carney made it just about as clear as was possible. Even if the Fed starts to tighten monetary policy sooner rather than later, and the dollar rises as a result, putting the pound under pressure, the Bank of England will not necessarily follow suit.
The pound fell sharply on the news. At one point last week there were less than 1.49 dollars to the pound. That was a three year low. But then Fed chairman Ben Bernanke appeared to do something of a backtrack, and the pound rose back up, finishing last week with an exchange rate of 1.51, which actually was nothing out of the ordinary – not over the last year or so, anyway.
It may be worth making a few comments at this point. Firstly, the Fed’s attempt to clarify last week, and reassure us about monetary policy was about as unambiguous as a disco dancing sloth. Frankly, Bernanke didn’t really appear to say anything new, and it is clear that opinion is divided amongst his colleagues at the Fed. The timetable for the Fed tightening its policy – namely reducing QE later this year, removing it altogether next and upping rates in 2015 – seems to be unchanged. But because Ben used some nice reassuring words, the markets seemed to love his comments. Equities lifted, pushing the Dow and S&P 500 to new all-time highs and alleviating pressure on the pound, as they somehow concluded that there was something new in the Fed’s words and that monetary policy will not be tightened as quickly, after all.
Secondly, the pound may have fallen against the dollar, but the UK press missed the wider story. This was not so much a case of a falling pound as a rising dollar. The euro pound exchange rate has done nothing spectacular.
However, look deeper, and it appears there are reasons to expect sterling to fall.
For one thing, a comparison of UK unit labour costs with the rest of the world suggests sterling is overvalued. The real effective exchange rate (based on IMF data) is 7 per cent above the level seen in the mid-1990s and 20 per cent above the level in the mid-1970s, or so says Capital Economics.
For another thing, something a little disturbing has happened to the UK’s balance of payments. We are used to seeing a deficit on trade in goods and services, but at least income from investments flowing into the UK tends to be greater than income flowing abroad. But there are signs that this is changing. The UK’s net investment income has been negative in three out of the last four quarters. The story here is complicated. The value of investments held by foreigners, but relating to the UK, is much greater than British investments abroad. But UK investments held abroad tend to be higher risk, and generally provide a much higher return. There are signs that this is changing, however, and that is a worrying development. To be clear, if net investment income continues to be negative this will put pressure on sterling relative to most foreign currencies, not just the dollar.
While is it the case that the real currency story of the last few weeks has been one of the dollar versus the rest of the world, across much of the global economy central banks have responded by upping interest rates themselves. For example, they rose last week in Brazil. China’s central bank is tightening, and rates were recently increased in Indonesia. The story is not clear cut – these things never are, but as rates rise in the US, leading to a stronger dollar, many other countries will probably follow suit. If the UK and Japan loosen monetary policy at such a time, they will be in the minority putting both the yen and sterling under pressure against a basket of international currencies – not just the dollar.
On the other hand, the prospects for the UK economy have been improving of late, and it would be odd if sterling tumbled just as UK plc began to show signs of pulling out of its downturn.
But supposing it happens and the pound falls much further, what then?
At a time when there are signs of improving exports, especially to the US and outside Europe; at a time when some anecdotal and some hard evidence (see car exports) points to a mini renaissance in the UK manufacturing industry and its exports, a cheaper pound will give exporters even more of a lift.
On the other hand, a falling pound may lead to rising inflation, and in this respect the UK has previous. Think of 1967 and the pound being devalued and the then Prime Minister Harold Wilson saying it will “not affect the pound in your pocket.” In fact sterling’s devaluation did - UK inflation shot up soon afterwards.
And that brings us to the UK’s big dilemma.
Yes we need exports to help lead recovery, but we also need increases in average wages to start outstripping inflation again. A cheaper pound may help us achieve the former, but most certainly not the latter.
What the UK really needs is productivity to rise, and that needs more investment; more investment in business, in entrepreneurs, infrastructure and education – and, it may seem like a cliché, investment in education in creating more engineers, because that is where the real labour market shortage is likely to be.
There is a danger, however, and to read about that, see What will happen to households as rates rise?
© Investment & Business News 2013