Three decades after Britain was forced to leave the European Exchange Rate Mechanism, fears of a new sterling crisis are spreading across markets. The currency is hitting 37-year lows against the U.S. dollar just as the country’s current account is at a record deficit and borrowing is about to jump to finance new Prime Minister
‘ plan to freeze energy bills, which could cost north of £150 billion, equivalent to around $169 billion.
But worries about the pound might be exaggerated.
The Bank of England’s monetary tightening program is failing to shore up the currency because other nations are doing the same. On Thursday, the BOE increased interest rates by half a percentage point to 2.25%, even though many investors expected a 0.75 percentage-point rise—which the Federal Reserve delivered for the third time in a row Wednesday.
Fearful investors point to Britain’s current account—a record of a country’s transactions with the rest of the world—which had an unprecedented deficit of 8.3% of gross domestic product in the first quarter due to more expensive commodity imports.
The standard analysis is that officials must be wary of scaring away all the hot money buying British stocks and bonds, because it is financing the country’s vital imports. The implication is that trade must eventually balance and that “sterling must find a level where ‘the kindness of strangers’ is willing to fund the deficit,”
strategist Oliver Brennan wrote to clients this week, referring to an expression channeled from Tennessee Williams by former BOE Gov.
However, the idea that hot money finances imports is misleading. When foreigners buy a U.K. asset—say, shares in jet-engine maker
—they give another asset of equal value in return, like a U.S. dollar deposit in a bank. The result is a net capital flow of zero. A net flow only shows up in the current and financial-account balances when an asset is swapped for something that isn’t an asset, like goods and services. These are independent processes: Rolls-Royce doesn’t issue equity to flighty investors to pay for its aluminum imports.
In developing countries where foreign investment is scarce—or banned, as in Russia—the only reliable conduit for foreign currency inflows does tend to be net trade, which therefore provides a decent explanation for exchange-rate moves. For the U.K., though, purely financial trading often dwarfs transactions reflected in the current-account balance. In 2016 and 2020, as currency volatility jumped around Brexit and the pandemic, respectively, net current-account flows hovered around 6% of GDP, whereas financial flows—halved to avoid the double counting involved in asset swapping—amounted to roughly 20%, official data suggest.
What this means is that the pound doesn’t need to “balance” trade—which, by the same token, won’t be stimulated by currency falls. The aftermaths of both the 2008 financial crisis and the Brexit referendum showed that a weaker exchange rate does little to boost exports in an economy focused on manufacturing intermediate goods.
The currency’s value is instead determined by finance. The unkindness of strangers has indeed made sterling plunge, pushing up the price of imports. The big reason why is well known: The latest indicators point to a recession that is likely to be deeper in Europe than in the U.S. The pound is holding up better against the euro, indicating that this is mostly a strong-dollar story, not a specifically British crisis. Ms. Truss’s plans aren’t likely to change the big picture and might improve it by reducing headline inflation.
The U.K. has enough problems to add a made-up one to the list.
Write to Jon Sindreu at email@example.com
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