Taking a pounding

As comments from British UK politicians increasingly point in the direction of a hard Brexit, currency markets have made their own judgment on what this means for the economy by heavily marking down the pound. Indeed, the FT reported this week that the trade weighted index fell to its lowest since the data were first compiled in the mid-nineteenth century. One way to think of the exchange rate is in terms of risk-adjusted uncovered interest parity. The UIP condition simply says that the expected change in the exchange rate is equal to the interest differential between two countries. But the movement in sterling since June is far bigger than can be explained by interest rate movements. Economists tend to explain away such differences by assuming it represents an exchange rate risk premium. In the case of the UK, this has just got a lot bigger.

This risk premium reflects unidentified risks (e.g. the breakup of the UK in the wake of the EU vote). It ought more properly to be called the uncertainty premium, reflecting the fact that economists characterise risk as something which can be priced but uncertainty as something which cannot, although this may be a matter of semantics. One concern is whether the international financial community will continue to fund the UK’s current account deficit, which at 5.9% of GDP in Q2 2016, is the largest relative deficit in the industrialised world. As MPC member Kristin Forbes noted in an excellent speech earlier this year “current account deficits of this magnitude can increase a country’s vulnerability to a sudden stop in capital flows and correspond to a difficult economic adjustment as the deficit reverses.”

Pre-referendum, the current account deficit had little impact on currency market thinking. One of the reasons for this is that the UK’s net international investment position (NIIP) remains decent, at just -3% of GDP at mid-year – way above the -25% to -30% range traditionally associated with a “sudden stop” in funding. Up to now there have been few indications that the rest of world is unwilling to lend to the UK. A lot of this is to do with the structure of the UK’s balance sheet. As BoE Deputy Governor Ben Broadbent pointed out in a speech in 2014 the UK balance sheet is (i) underweight sterling; (ii) overweight maturity and (iii) overweight risky assets. Point (i) implies that the UK balance sheet is exposed to significant capital gains when the currency depreciates. Point (ii) suggests that to the extent the global yield curve is upward sloping, the UK earns “carry” on its international asset position. And point (iii) suggests that rising global equity prices are good news for the UK’s asset position.

Putting all these together suggest that the NIIP is likely to remain well supported for now, which in turn implies that the UK will remain a good credit risk and should not have to worry about attracting the capital from abroad to fund its external deficit. But this does not mean that the pound will not depreciate further. Indeed, to the extent that the risk premium is volatile, the pound could go higher or lower from here depending on the market’s assessment. However, as Forbes noted in her speech “sterling tends to depreciate during periods of heightened UK and global risk.” Although the risk of a “sudden stop” is limited, if foreign direct investment slows as a result of the EU vote, it may mean that the UK becomes more reliant on “hot” money capital inflows which will increase sterling volatility.

Even if the pound does not go lower from here, the fall over the past three months will make its presence felt in the inflation statistics sooner or later. This will make consumers worse off if not compensated by a rise in wages – which is unlikely given that a potential Brexit will raise the competiveness pressures on corporates. The BoE’s ready reckoner analysis indicates that a sustained 10% depreciation of sterling will increase CPI inflation by around 0.75 percentage points “after two to three years.” With the pound having fallen by 15% since 23 June, we are setting ourselves up for a rise of 1% in inflation over and above what would otherwise occur. The attempt by Unilever to push through a 10% rise in the price of Marmite, which was resisted by Tesco, was merely the first sign of things to come. And for those of you taking part in the EuroMillions lottery, you may have noticed that the price of a ticket recently rose by 25% which (a) raises the stakes if you want to try your hand at becoming a millionaire and (b) materially reduces the rate of return at the lower end of the prize scale.

The puerile effort by commentators such as Simon Heffer to suggest that “the City traders betting against the pound are ignorant teenagers without the foggiest idea what Brexit means” is a complete misrepresentation of what the international community believes Brexit means for the economic future of the UK. Foreign investors now face far greater political and economic risks associated with their investment in the UK. This is not about teenagers pushing buttons (not that there are any teenagers working in FX markets). It is hardened investors making an assessment of what Brexit means for the UK and it is a message we ignore at our peril.