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20 August 2017

What the fall of the Sterling really means

Last Friday the Sterling closed at 1.094 to the Euro. Not only is it a remarkable figure for crossing below 1.1, it is the lowest weekly close since 2009. In effect, since the common currency was introduced to currency markets in 1993, the Sterling closed against it below this level only in eleven other weeks. They all took place between December of 2008 and October of 2009, at the height of the housing crisis, when European institutions failed to address financial markets with the haste seen in grown-up economies.

This brief note puts this monetary devaluation into a broader perspective, within the context of the UK's exit from the EU. Sterling is just a visible facet of an overall economic setting deteriorating in anticipation of the UK's shift into a new - and largely unknown - economic paradigm.

Unlike in 2008/2009, this time there is no economic crisis to justify the fall of the Sterling, much to the contrary, and the wild swings in exchange rates witnessed back then are now oddities. The weakness of the Sterling is not the product of market volatility, it is now a clear secular trend settling in. Since December of 2015, when the UK's House of Commons confirmed the referendum on EU membership, the Sterling lost 23% of its value against the Euro.

Weekly Sterling-Euro exchange rate movements. Graph from Live Charts.

So far UK households have felt this devaluation primarily in rising prices of consumer goods. In a phenomenon popularly dubbed "Shrinkflation", consumers face a decrease in the quantities packaged of thousands of products, from chewing gum to toilet paper, even though prices remain as before.

But it is at the macro scale that the challenges posed by this devaluation are most visible. Inflation is rising considerably faster than wages (2.7% against 1.8%) eroding purchasing power; consumer spending falters and the UK is now among the slowest economies in the EU and the world. And when account in US Dollars or Euros, the UK's GDP is in clear decline.

The UK's GDP in Euros and US Dollars. Data from Trading Economics and Statista.

There is though something even more worrying brewing: the trade deficit is still widening. A weaker currency would in normal circumstances mean a boost to exports and an improvement of the trade balance, but in this case rising imports have canceled out the effect. The secular trade deficit widening trend that set in after the peak of North Sea petroleum and gas extraction in 2000 remains intact. In consequence, private debt is surging relentlessly.

The UK's long term Trade Deficit. Graph from Trading Economics.

This state of affairs has greatly narrowed the range of monetary and economic policies available to the Bank of England and the Exchequer. Rising interest rates to tame inflation and support the Sterling would threaten the fragile economic growth and widen further the trade deficit. The status quo equates to continued Sterling weakness, loss of purchasing power, declining consumer spending and a billow of private debt. Institutions must now recur to the "imagination" so often referred in the context of Article 50 negotiations to develop their policies.

In his mid year press conference, the Governor of the Bank of England left some subtle references to the constrictor these trends are circling around the UK's economy:
Monetary policy cannot prevent the weaker real incomes likely to accompany the move to new trading arrangements with the EU. But it can influence how this hit to incomes is distributed between job losses and price rises, and it can support UK households and businesses as they adjust to such profound change.
The governor means to say that Sterling is not the priority, jobs are. And so far it has succeeded, as the UK hits its lowest unemployment rate in more than 40 years. But just a week earlier the governor had something rather different to say, as UK banks were requested to raise contingency capital:
Consumer credit has increased rapidly. Lending conditions in the mortgage market are becoming easier. And lenders may be placing undue weight on the recent performance of loans in benign conditions.
This is the Bank of England trying to square the circle.

One of the policies that could be tried at this time would be raising wages, possibly changing the minimum income legislation. This would not address the widening trade deficit and would put pressure on economic growth. The Bank of England could in its turn attempt to support the Sterling by using its foreign currency reserves, counted in the order of 160 G$. However there are some 380 G$ in gilts and other Sterling denominated debt instruments held overseas. If it ever comes to that, it will be an uneven fight. Moreover, the Bank of England can hold to its "jobs first" policy only for so long, if the Sterling comes to be perceived as a currency in demise a deluge of these foreign reserves may unfold. In such a scenario the Bank of England would effectively lose control over the Sterling.

This is just a prelude to the exit of the UK from the EU and the EEA. These trends shall remain in place, with Sterling-Euro parity a real possibility in the following six months. The UK government has just published its Article 50 negotiation position in a number of areas, sitting itself an ocean apart from what the EU is willing and legally able to accept. The first breakthroughs in these negotiations, initially expected to October, have already been postponed to Christmas. By next Spring various industries will be preparing their post exit offerings and business plans. The possibility of no concrete agreement being in place by then renders any economic predictions attempted now a futile exercise.