Should we worry about sterling? Since February this year, when the referendum on the UK’s membership of the EU was announced, sterling has fallen by 15% against the US dollar. There are two significant points on this trend. In the aftermath of the Brexit vote, the value of sterling dropped by 9%. Then, at the beginning of October when the government appeared to signal a preference for a clear cut with the EU – a ‘hard’ Brexit – sterling dropped again by 6%. The value of the currency is clearly correlated to Brexit and has been consistently indicating uneasiness about what looms ahead.
A weak currency is not much help for an economy that imports more than it exports. The UK has a significant deficit in its current account – roughly, it consumes more than it produces – and this is almost 6% of GDP. Of course, a weak currency would lower the prices of exports, but only if these goods are produced with limited inputs from imports. In a world of global supply chains this is questionable. Even assuming that weak sterling would help shifting the UK model of growth from domestic demand to exports, this adjustment will take time and is unlikely to cushion the adverse impact of Brexit on real GDP growth in the next few years.
In addition, a weak currency is problematic for an economy with a high level of indebtedness, both in the private and public sectors – in the UK the household debt ratio is approximately 87% of GDP and the government debt ratio is 108%. Attracting and absorbing high levels of foreign capital – and foreign labour – is critical to maintain financial stability and to support the UK consumption-led model of growth.
In a forthcoming Chatham House paper, my co-author and I argue that the UK model of growth needs to be assessed against all the possible options that the UK government is considering for the new relationship with the European Union. The ‘hard Brexit’ option, by reducing market openness, will affect investors’ confidence, have an adverse impact on capital inflows and undermine growth. If the UK becomes less attractive as an investment destination, and stricter immigration policy causes the labour force to shrink, then it may find it difficult to attract the quantity of foreign capital – and labour – necessary to keep a domestic demand-driven economy. Sterling has already been severely hit by Brexit, and it is reasonable to expect a further deterioration in the sterling exchange rate if net capital inflows to the UK shrink.
Currencies not only reflect patterns of trade and debt, but also geopolitical dynamics, so there is more to this story than just short-term exchange rate movements. Sterling has been a currency on the downward trend over the last 80 years – this trend began in 1931 when Britain left the gold standard. Yet, lack of alternative assets and the importance of London capital market have maintained sterling in the group of key reserve currencies – the IMF’s SDR basket. To some extent sterling has been a proxy of British global influence: on the way down, but still ‘punching above its weight’. However, sterling’s protracted weakness coupled with the inclusion of the Chinese renminbi in the SDR basket – with effect from the beginning of October – may result in the downgrade of the British currency when the composition of the basket will be reassessed in 2020. For Britain this will be the last step of a long process of shifting economic dominance while Brexit represents the abdication of the active role in international economic policy coordination that Britain has played since the establishment of the Bretton Woods system in 1944.
If currencies are an expression of national sovereignty, they also epitomize the limits of such sovereignty in an open economy, as Martin Wolf reminds us. Exchange rate dynamics tend to reflect divergences between domestic politics and global markets. Thinking that domestic policy-making can be insulated from the rest of the world, so that no coordination or cooperation is needed, is deeply fallacious. Sterling’s troubles are a reminder that foreign investors have an indirect say – and interest – in how a country is managed. Depending on other people’s money sets a natural limit to sovereignty for any country that needs steady and abundant capital inflows.
Dr Paola Subacchi, Research Director, International Economics.