U.K. pound’s post-Brexit plunge echoes past crises
Throughout the 20th century, Britain endured a series of currency crises that exposed its decline as a major global power.
The recent slide in the pound sterling has reawakened memories of those troubled times, including one in the mid-1970s when the country ended up needing an international bailout.
And it has raised questions of whether another so-called “sterling crisis” might push the government to soften its plans to break away from the European Union and its single market.
The pound has fallen by nearly a quarter against the dollar since the June 23 vote to leave the EU, from around $1.50 to a 31year low below $1.20. That scale of fall is equivalent to some of the great depreciations over recent decades, from 1949 through to 1992, that have caused upheavals in government policy and shaken the economy.
Simon Derrick, chief currency strategist at BNY Mellon, said the current drop in the pound is so far echoing how previous currency crises unfolded: “Given historic movements, it’s been very much business as usual.”
Though a weaker pound can boost exports and help rebalance the economy from being overly reliant on consumption rather than trade and investment, standards of living in the country could drop in coming months as inflation pushes higher. A weaker currency makes imported food and other goods like fuel more expensive and reduces purchasing power abroad.
The pound’s drop has hastened since new Prime Minister Theresa May indicated that her government hasn’t ruled out a complete break from the EU single market, which could bring back expensive tariffs for trade with the other 27 EU countries, if that’s what is needed to limit immigration.
So far, it seems May — like many of her predecessors at 10 Downing Street — is prepared to let the pound weaken as it helps cushion the impact of the Brexit shock on the economy by boosting exports. But there is a limit to what she and her government will be willing to endure.
Derrick says that limit could be when the pound hits one-to-one with the euro or the dollar, something that has never occurred with either currency. At present, the pound is worth around $1.23 and 1.12 euros.
“It (parity) will resonate with a government that is still pretty fresh,” said Derrick. “They will be well aware that criticism will start to mount.”
Should the pound drop to such levels over the coming months, inflation will likely pick up to rates that have a real impact on households’ incomes. And British holidaymakers will, if they haven’t already done so, see how much less their money buys them abroad — effectively making them poorer.
It is these sorts of unintended consequences that have historically gotten governments concerned.
Official figures this week showed the annual rate of inflation is running at a near two-year high of 1 percent — even before any notable impact from the fall in the pound. Some analysts estimate it could hit 4 percent by 2018, which is double the Bank of England’s target.
For Jane Foley, chief currency strategist at Rabobank International, the government is less likely to be concerned about the absolute value in the pound — unless truly calamitous — but rather continued volatility in the currency. That would make it more difficult for companies to plan ahead.
“High levels of volatility can have a detrimental impact to the economy,” Foley said. “In some instances the size of a currency’s movement may have greater relevance to policymakers than its actual value.”
The pound’s drop is evoking memories of one of the most defining moments in post-war Britain, when in 1976 the then Labour government had to approach the International Monetary Fund for a loan after the currency fell by a quarter to a then record low against the dollar.
In return for the loan — at $3.9 billion, it was the largest the IMF had ever made — the government had to change economic policies and cut spending and clamp down on wages. The prescription is the same as what Greece is being forced to do today.
The episode trashed Labour’s reputation for economic competence and fostered the rise of the freemarket ideology and the rise to power in 1979 of Margaret Thatcher’s Conservative Party. But the Conservatives also saw their reputation for economic competence damaged when in 1992 the pound was ejected from a fixed European exchange rate system that was the precursor to the euro.
One mitigating factor today is that Britain’s economy appears on the whole more able to withstand a similar drop in the pound. In 1976, for example, the price of oil had recently quadrupled, sending inflation to around 25 percent. Interest rates soared to 15 percent, compared to near zero today.
If the pound does drop more sharply, the Bank of England could be the first responder in any attempt to stabilize it.
BNY Mellon’s Derrick doubts the government would request that the central bank intervene directly in the currency markets to prop up the pound by buying it and selling other currencies. That’s partly because the country’s foreign exchange reserves wouldn’t last for very long in today’s multi-trillion foreign exchange market.
But the Bank of England, which is independent from government on setting interest rates, could look to tighten monetary policy, such as by raising interest rates, if it becomes concerns about inflation rising. That would likely support the pound — higher rates tend to bolster a currency.
There’s a catch. Higher rates would also further hurt the economy and put pressure on households by making mortgages more expensive.
Conservative Party leader Margaret Thatcher holds up five one-pound notes during a speech April 30, 1976, in Finchley, North London. “Every time you spend five pounds,” she said, “the Government owes one to creditors abroad.” The pound has endured a similar devaluation since the country voted to leave the European Union in a referendum on June 23.