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18/07/2016

Sterling has been falling since the referendum… in 2014

Perhaps the most discernable market impact of the EU referendum has been the dramatic fall in the value of the pound. Relative to the US dollar, it is at its lowest since July 1985, slumping 13% below its pre-referendum level. Media headlines have proclaimed a “historic” devaluation. But is this true?
First, sterling is still a long way from its all-time low of $1.04 on 26 February 1985, when the US dollar was at a peak against a number of global currencies, in part due to high US interest rates that were set to fight inflation. The dollar subsequently underwent a coordinated weakening against other major currencies following the Plaza Accord in September 1985.
Second, sterling has been at $1.65 on average since the Plaza Accord, trading roughly between $1.50 and $1.80 two-thirds of the time. However, it is hardly unprecedented for it to breach those levels. In the mid-2000s, interest rates in the UK were marginally higher and inflation was lower than the US. As a result, sterling deviated further from its average, relative to today, as it was 26% higher than its post-Plaza average (figure 1).
Third, while sterling has moved a long way following Brexit, the direction of travel is hardly new. It has been depreciating in US dollar terms for two years, ever since the Scottish independence referendum. This has had little to do with politics and more to do with the US Federal Reserve tapering its quantitative easing programme. Furthermore, the US economy was the standout performer in 2014, growing 2.4% in real terms, far outstripping most of the developed world. While the UK economy kept pace, there were a number of questions regarding the sustainability of its recovery as well as its exposure to a European recession and its toxic banks.

Trade weighting

Fourth, while it is conventional to compare sterling to the US dollar – the US is the UK’s biggest single trading partner – the pound is far above its lows on a trade-weighted basis. Trade-weighting takes into account the movement in the currency versus others in proportion to their importance vis-à-vis imports and exports. For example, the US accounts for 15% of the UK’s trade, less than Germany and Switzerland combined. While Brexit has undoubtedly dented sterling’s trade-weighted value, it is far from unprecedented (figure 1).
Lastly, currencies are a powerful way to achieve a competitive advantage. There is evidence of large and rapid devaluations providing economies with a tremendous boost. It makes domestic goods cheaper and foreign goods more expensive, tilting consumption preferences towards local producers. In turn, this process increases domestic output and lowers unemployment by exporting it.
In the past 20 years, developed (Sweden, Iceland and South Korea) and emerging (Indonesia, Thailand, Brazil and Argentina) countries have experienced large devaluations. On average, GDP grew strongly in the years following those devaluations, driven primarily by household spending and exports. The prospect of this surge in growth is a powerful incentive for governments and central banks to attempt to weaken their currencies. Indeed, policymakers have been actively trying to devalue their currencies – the infamous “currency wars” – by monetary means. The Bank of England may just have got lucky.

Figure 1: Down but not out
Although Brexit has dented sterling’s trade-weighted value, recent levels are not unprecedented.

Source: Factset and Kleinwort Benson. Data as at 30 June 2016.

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