A devaluing sterling

©dailymail
©dailymail

I recommend before reading this post that you zoom out (“cmd-” on a mac) as the text will be easier on the eye.

Over the past week the Sterling saw it’s biggest decline vs. the Dollar since last June, falling -1.7% last week to $1.5861. The Sterling also depreciated -1.5% against the Euro to £0.8383, after hitting a low of £0.8395 it’s lowest since March 2012 (source; bloomberg).

What does this say about the UK economy, and what are its effects? This blog will explore why the Sterling has depreciated so rapidly (and is expected to continue into next week) and the economic effects of such a change.

The causes of this depreciation

There are a number of factors, which have caused the Sterling to depreciate:

  • Strengthening Eurozone

With the Eurozone problems seemingly under control for now there has been restored market confidence. This has caused money to start flowing back to other countries in the Eurozone, as opposed to the ‘safe havens’ of Germany and Britain. The value of a currency is driven by supply and demand, with a decreased demand, the supply of sterling is beginning to exceed demand and as a result the value has fallen.

UK 5-yr gilt yields have raised 6 basis points and German 5-yr government bond yields have risen 22 basis points over the past month (0.06% and 0.22% respectively), showing investors are demanding less safe-haven investments (source –Gilts, source –Germany).

  • Leaving the Eurozone?

David Cameron is due to give a speech regarding Britain’s future with the Eurozone, it planned to occur last week but due to the Algerian crisis it has been postponed. Bloomberg writes: “Extracts from the speech released by Cameron’s office last week put 40 years of integration with the continent on the line by raising the specter of a U.K. exit from the EU. “More of the same” won’t be enough to guarantee the EU’s future because of British dismay at a lack of consent to their alliance within the 27-nation bloc, Cameron planned to say.” (source).

Without the Eurozone the UK will face higher costs of trade, reduced labour mobility and a reduction in their ability to trade within the Eurozone. Companies such as Nissan might move their production to France or Germany to retain their entrance into the Eurozone market, which can be argued, was their main reason for setting up in the UK. All this is causing concern in the markets, and has been shown by a reduction in the value of the sterling.

  • Ratings downgrade

There are rumours floating round the markets suggesting the UK could be due a downgrade from it’s AAA rating, with S&P marking it on ‘negative outlook’. The UK failed to meet it’s austerity targets last year, it is running a large budget deficit (source;Guardian), retail sales declined, inflation remains a problem and it expected that the UK will have a negative 4th Q. All these problems are causing the market to begin to lose confidence in the Sterling, and explains it’s depreciation vs. the Dollar as well as the Euro.

The economic effects

  • Imports and Inflation

A weaker Sterling will cause Imports to increase in price, as a result of requiring more Sterling to purchase a product. This will have the effect of increasing the price of a consumer’s average basket of goods (CPI) and thus pushing up Inflation.

Example: A business buys 1,000 televisions for a bulk buy price of $1 million. If the sterling depreciates from $1.6 to $1.57 (-1.7%) the 10,000 televisions, which used to cost £625,000 will now cost £636,942. The majority of the increase of £11,942 will be passed onto consumers, if possible, increasing the price of a single television by £12.

With inflation already above the BoE’s target of 2% this could make matters worse and with little scope to increase interest rates (or risk further economic problems) the UK could face a tough year

  • Exports

Exports should, theoretically, increase. A weaker sterling will make UK goods and services cheaper to the rest of the world, increasing their competitiveness and their demand. As a result the manufacturing sector should get a boost from a weaker sterling.

©google
©google

However we saw a large depreciation in 2008, when the £vs.$ fell from $2 to $1.5 and yet there hasn’t been the manufacturing recovery we were hoping. This time round, however, industry might be slightly stronger as a result of the previous depreciation and they might have more money to invest in competitiveness.

The result could be a J-Curve, that started in 2008 – got worse as imports got more expensive, but becomes more beneficial to the UK economy as imports fall and exports rise.

jcurve

If you can strike a fine balance, increasing exports and decreasing imports, the effect of a depreciation should be to narrow the balance of payments – helping move the UK into a surplus. However it all depends on the elasticity of demand for imports, which is relatively inelastic considering we import such a variety of necessity items.

We will have to wait and see how the Sterling fares over the next month; GDP growth/decline will be a large factor in the fate of the Sterling, as well as a possible ratings downgrade. We hope that exports will pick-up as a result of the decline of the Sterling, but the extent to which it might occur can be debated.

Ed

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