Seldom do events in the foreign-exchange market dominate mainstream news. Yet, over the past week or so, Britain’s beleaguered pound sterling has fallen to a 168-year low. Why does this matter? And what does it mean for the British economy?
To help make things clearer, its important to remember what an exchange rate is: a price. Or, more precisely, the price of one currency, against another.
On June 23rd, the eve of EU referendum, one pound bought you close to $1.50. At the time of writing, that same pound now only buys you $1.23, representing an unprecedented fall of nearly 17% in the space of less than four months. More importantly, almost half of this decline has occurred within the last week alone. But why?
Most commentators point towards the prime minister, Theresa May’s recent speech at the Conservative party conference, which decidedly indicated that the government’s position is ostensibly poised towards a ‘hard’ Brexit in which Britain pulls out of the single European market and customs union.
In this potentially damaging scenario, exporting firms based in Britain would face significantly higher costs when selling goods and services to Europe. And at the same time, European consumers may then be less inclined to buy British goods and with it the pound sterling.
However, in a world of largely flexible exchange rates, the devaluation of any currency is the mechanism by which an economy, such as Britain’s, can accommodate (and hence mitigate) a decline in export demand. So, are recent events a good thing (as most Brexiteers believe and want you to believe it to be) or should we be worried? As with most things in economics: it depends. But the evidence suggests more convincingly to support the latter case.
There are two key elements to understand, firstly:
1. Other currencies are now ‘more expensive’:
This has two basic effects: imports are now more expensive and foreign assets, such as stocks and shares, are also more expensive.
As the price of other currencies increases –such as the dollar– goods and services imported from abroad also become more expensive, potentially leading to higher levels of inflation in the UK.
Whilst this isn’t a one-to-one relationship, when looking at the fact that, proportionally, Britain imports more than that which we export, inflationary pressures will undoubtedly begin to appear. This, in turn, may lead to the need for higher interest rates which could further exacerbate the already sluggish demand in the economy (as the cost of borrowing begins to rise).
The recent Tesco and Unilever row over the price of Marmite neatly illustrates this point. Unilever, an Anglo-Dutch multinational, reports its earnings in euros. So, with a devalued pound, its earnings from the sales of Marmite in the UK (in euro terms) are now less than before, which ultimately hits their profit margins. The same line of logic is true for many UK based firms that depend heavily on imported goods and services as key inputs into their production process.
On the other hand, foreign assets have also become more expensive. Longer-term, this matters particularly because institutional British investors –such pension funds– with exposure to dollar denominated assets, will see their returns squeezed: which is bad news for everyone, not just pensioners.
2. The pound is cheaper:
From the point of view of foreigners, the pound is now cheaper. That means that British exports and domestic assets are cheaper, or more price competitive, too.
This explains why the FTSE 100 is booming: foreign investors are wisely taking advantage of cheaper share prices. This may also provide a welcome boost to UK M&A activity, as foreign companies attempt to capitalize on opportunities to either buy up or merge with attractively priced UK companies.
In the case of exported goods and services, this is the so-called adjustment mechanism at work once more. If demand for British goods and services does begin to decline from Europe, the weaker currency should mitigate this effect by, again, making British exports more price competitive and thereby increase overall sales volumes.
However, the real question is whether or not any potential volume boost will offset the rising import costs faced by UK firms.
Whilst British assets become cheaper in foreign currency terms, this will do nothing to abate the ever-widening gap in income and wealth between asset-holder and non-asset holders. International investors, for example, will find the potential prospect of investing in London property even more enticing.
Two sides of the same coin
The long-term impact of the pound’s crash depends largely on what happens over the next few weeks. If, as is suspected, the pound’s value remains where it is now, the economy will undoubtedly begin to experience a rise in inflation, as Mark Carney, the Governor of the Bank of England has already indicated.
Since wages are unlikely to rise in response to this, it may well be that the poor, in particular, are left worst off. Brexit may mean Brexit but sadly, it may also mean adjusting to a reality of higher prices (not just Marmite) and lower overall living standards. So much for project fear, hey?