What a long-term weak pound means for the UK economy

A British one pound coin sits in this arranged photograph in London, UK

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LONDON — The exchange rate of the pound sterling against the American dollars has been on a roller coaster ride for the past few months.

After a year of steady decline, it plunged to an all-time low below $1.10 after the UK government’s infamous “mini budget” in late September. It then fell back to $1.16 after the country swapped finances and prime ministers in late October; and fell to $1.11 after the Bank of England downplayed rate hike expectations and warned that the UK had already entered its longest recession on November 3.

The recent highs and lows have all taken place within a range where the British pound has not traded against the greenback since 1984. In mid-2007, at the height of the financial crisis, it was possible to get two dollars for a pound. In April 2015, it was still worth $1.5; and in early 2022, $1.3.

Almost all currencies fell against the dollar this year, and the depreciation of the pound against the euro has not been so severe given the European Union’s own challenges in terms of economic slowdown and energy supply.

But the euro is still much stronger than it was against the pound in the 1990s and most of the 2000s; and the pound’s global importance has evaporated since it was the world’s reserve currency in the early 20th century.

How

A historically weaker pound over the medium to long term has various impacts on the UK more broadly, economists told CNBC.

The most fundamental is that imports become more expensive, while exports theoretically become more competitive.

“The problem is that the UK is very import dependent, almost two thirds of food is imported, so a 10% drop in the real effective exchange rate translates really quickly into higher food prices” , said Mark Blyth, professor of economics and public affairs. at Brown University.

“The UK is a low-wage economy. This is going to hurt.”

Long-term situation

Richard Portes, professor of economics at London Business School, also noted the UK’s dependence on foreign trade, meaning a “significant” impact on the prices of a weaker currency, although he said there was not yet evidence of a significant effect on UK demand. for foreign goods – but neither was there for exports, which theoretically become more competitive.

He also noted that currency depreciation had a level effect on prices rather than being inflationary.

“It’s a one-time effect. It doesn’t necessarily give us inflation in terms of a continuous increase in the price level,” he said. “If it contributes to a spiral in wage prices, then it is inflationary, and that is what we are all concerned about now. We do not want to see these price increases which have happened partly because of Ukraine , etc. I don’t want to see wage increases that will trigger price increases and a spiral.”

The depreciation of sterling has been a long-term trend since it was allowed to float freely in 1971, he told CNBC: “I think it’s reasonable to expect that And that’s partly because productivity and therefore competitiveness hasn’t been very good compared to our trading partners, so that’s the long-term situation.

The UK’s current account deficit (where a country imports more goods and services than it exports, and amounts to £32.5 billion for Britain) is financed by capital inflows, he noted. Former Bank of England Governor Mark Carney has said the UK depends on the “kindness of strangers”. But Portes said “it’s not their niceness, it’s them who want to invest because they find their projections and returns possible, investors find UK assets attractive enough to bring in capital.”

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“If they find it less attractive, UK assets would lose value to entice people to invest more, so the exchange rate would fall further. It depends on confidence in the UK economy, fiscal policy and of all these things.”

But, Portes said, the weaker pound is not in itself a problem for the budget planning the government is doing, with a much-anticipated budget due on November 17.

“If a lot of our debt was denominated in foreign currency, it would be, but it’s not. Our public debt is denominated almost entirely in sterling. And so, unlike some countries, we don’t find “That’s not a problem. I don’t think the depreciation that we’ve seen or that’s likely to happen over the next few years will make a big difference to fiscal positions.”

“The growth model is dead”

According to Blyth, beyond the pain suffered by households, the price increase caused by a weaker currency will have deeper and more lasting effects.

“The UK is a heavily consumption-based economy, and such a change is tantamount to a tax on consumption. It means less fuel in the economic engine. The UK already has low growth and growth in even lower productivity.

Upside potential for exports has been negated by Brexit, he said, pointing out that Britain’s economy had shrunk from 90% to 70% the size of Germany since the 2016 vote.

“So what does this mean in the long term? It means the old British growth model is dead,” Blyth continued.

Expect more volatility in UK market, says strategist

“Financing your consumption from other people’s savings (capital imports) and exchanging overpriced houses had a lifespan. It’s over. The combination of a structural fall in the exchange rate and a positive inflation puts an end to it.”

The allure of cheap UK assets only held if they needed to be repriced, he said, and “GBP is not USD. Period.”

Adapting to this new reality will be painful but necessary in the long run, Blyth believes.

“A UK that is not dependent on Greater London generating 34% of GDP, with subsistence transfers from the north and west, is a better UK. It will just take time, imagination and investments to get there.

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