Brexit and the pound

Economics is the study of how people make choices under varying degrees of certainty. But it is the lack of certainty which concerns us at present as global geopolitical considerations impact on investors’ assessment of asset valuations. Here in the UK, the issue of Brexit further adds to the mix. We hear a lot about how this raises the risks to UK financial assets. However, we have to make a distinction between risk and uncertainty. As the economist Frank Knight put it almost a century ago in one of the earliest and most influential works on investment risk-taking, “there is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.”

The valuation of risk underpins the insurance industry where actuaries have some idea of the possible range of outcomes. But there are some risks which we cannot hedge because we have no idea of the possible range of outcomes. Brexit falls into this category. Although there has been much concern about the fall in the pound in recent weeks, as anyone who has recently been on holiday abroad can testify, in truth it has traded in a relatively narrow range over the past three years after the initial post-referendum decline. The Bank of England’s trade weighted index, which is a broad measure of sterling’s value against a basket of currencies, has traded in the range 73 to 80 compared to a wider range of 79 to 94 in the three years prior to the referendum. Admittedly, it has traded at multi-year lows against both the EUR and USD of late but given the magnitude of the risks involved, it still surprises me that the pound has not traded even lower. Ten-year gilt yields have traded at all-time lows in recent weeks, in line with global trends, suggesting that the bond market has no real concerns about the UK government’s creditworthiness.

If we were to infer what was happening in the UK purely from watching market moves, we would not conclude that it was going through the most dramatic political crisis of modern times. One explanation for this apparently paradoxical reaction is that the markets cannot price what form Brexit is likely to take, let alone what happens in the event there is no deal, and are holding fire as a result. In other words, markets are trading an uncertain environment rather than a risky one. But we can gain some idea of currency market concerns by looking at trends in implied FX volatility, which is a measure of how much the market expects the pound to move. Three month implied GBP/USD vol has recently traded above 14% (chart above) – ahead of the 2016 referendum it was at 16% (and reached 18% in the wake of the referendum outcome). Aside from the period following the Lehman’s crash in 2008, when global assets were priced for the worst, we are close to the highest recorded levels of idiosyncratic sterling FX volatility.

Of course, the one thing that volatility measures cannot tell us is in which direction the currency is likely to move. But it is accepted that in the event of a no-deal Brexit, sterling will depreciate sharply. Since it is impossible to give any accurate assessment of how big the move is likely to be, we are reduced to taking the volatility measures as a guideline and applying a significant degree of judgement (or guesswork, if you prefer). Forecasting exchange rates is difficult enough at the best of times and these are not the best of times, so the indicative levels shown here should be treated as no more than that.

In the case of no-deal, my guess is that the GBP/USD rate will stabilise around 1.15 (a decline of around 5% from current levels) although it could initially go sharply lower to somewhere around 1.10 before recovering, if the experience of June 2016 is anything to go by. As has become evident in recent days, there is plenty of scope for upside in the event that a no-deal Brexit can be taken off the table. In the extreme case where the UK revokes the Article 50 notification the pound can be expected to rally strongly. Indeed, a simple model based on expected interest rate differentials suggests that fair value for the GBP/USD rate is around 1.50. The chart above shows that since 2016, the exchange trade has traded outside the model’s one standard error bounds which we can attribute as the risk premium baked into the currency since the referendum. Using this model as a benchmark, I reckon that this risk premium results in sterling being approximately 20% undervalued versus the dollar. 

To the extent that the currency acts as a barometer of the market’s assessment of a country’s economic health, the recent slide in sterling reflects the downbeat assessment of the UK’s prospects. But whatever happens in future, it is unlikely that current market levels reflect a stable equilibrium. Either the situation with regard to a no-deal Brexit gets worse, in which case the pound might be expected to fall further, or it improves in which case sterling’s fortunes will also recover. The events of the past few days, in which the prospect of a no-deal Brexit has at least been temporarily been put on the back-burner, suggests that there is some room for optimism. But a more sustainable recovery is unlikely until a permanent solution to the problem is found.

This currency is a turkey

The top market story of the day has been the collapse in the Turkish lira which went from 5.60 against the dollar on Friday to around 7.00 at the time of writing – a collapse of 25% in one session. It is not as if the lira is coming off a period of overvaluation – quite the opposite in fact, since the currency has been sliding throughout much of the year. The root cause of the lira’s initial weakness was the failure of the central bank to tighten policy earlier this year. This resulted in the currency coming under pressure over the first four months of 2018, followed by a sharper depreciation following President Erdogan’s remark in May that “I will emerge with victory in the fight against this curse of interest rates … Because my belief is: interest rates are the mother and father of all evil.”

In short, Erdogan has peddled the view that rising interest rates result in higher inflation. To say the least, it is unconventional (though not necessarily wholly wrong if you have interest-rate linked products such as mortgages in the CPI basket, as the UK discovered 30 years ago, though that is not the case in Turkey today). As a result, Erdogan has browbeaten the central bank into holding off from monetary tightening. To make things worse, the political standoff between the US and Turkey has intensified in recent weeks, culminating in Friday’s response by Donald Trump to double the tariffs on imports of metals from Turkey. It is thus understandable that investors are feeling nervous and as a result Turkey has come into the market’s cross-hairs. But with the central bank’s credibility having been badly battered by its actions this year (or more precisely, by its inaction) it is difficult to see what it can do to stem the lira’s decline. It could jack up rates but once market confidence has been lost in the way that Turkey has experienced, this is nothing more than a futile gesture. Even a 100% annual interest rate amounts to just 0.19% on a daily basis. This is equivalent to trying to stop an elephant with a pea shooter. In other words, futile when the currency can decline by 25% in one day.

The other alternative is capital controls. One of the basic axioms of international economics is that economies cannot simultaneously run an independent monetary policy, a fixed exchange rate and free capital movement (the famous trilemma). On the assumption that Turkey wishes to regain some control over its currency, and on the basis that domestic monetary policy is likely to prove ineffective (as noted above), some restrictions on capital outflows appear to be necessary. Bear in mind that Turkey already runs a current account deficit, equivalent to around 5.5% of GDP last year. It thus has to borrow from the rest of the world to cover the fact that domestic investment is greater than domestic saving. Foreign investors are not going to be keen to lend to Turkey if they cannot get their money out. Theory would thus suggest that Turkey will have to deflate its economy in order to redress the savings-investment balance whilst the capital controls are in place.

This is exactly what the Asian Tigers did in the 1990s when currencies in the region came under speculative attack (though to be more precise, the policy was forced upon them by the IMF as a condition for financial assistance). Obviously, this does not bode especially well for Turkey’s near-term growth prospects, but people said very much the same regarding Thailand and Korea in the 1990s – and look at them now! There again, it did take five years for real GDP in Thailand to get back to pre-crisis levels.

The full effects of the Turkish lira collapse will continue to play out over the longer-term. Perhaps the Russian currency collapse of 2014-15 can offer some pointers. Ordinary citizens certainly did not escape unscathed, with consumers required to tighten their belts considerably. As in Russia, Turkish inflation is set to spike much higher. But whereas Russian inflation surged from 8% to 17%, Turkey is starting from an already-high rate of 16%. And the Russian central bank emerged with great credit as it managed the currency shock – the Turkish central bank’s stock is not exactly high.

One of the lessons we have learned from past currency crises is that what matters for the future is the nature of the policy response: Credibility can be regained if the authorities are prepared to make some hard choices. Moreover, despite the chatter suggesting that this could mark the start of an EM rout, we should not forget that Turkey’s problems are largely homemade. This is an object lesson of what happens when we try to run economic policy along populist lines, with Erdogan’s attempt to hold down interest rates to make life easier for his supporters about to backfire spectacularly. Populists of the world take note.

Taking back control

It is convenient to link the current state of the UK’s relationship with the EU to the events of 25 years ago today, when on 16 September 1992 the UK suspended its membership of the European Exchange Rate Mechanism (ERM). This is not as ridiculous as it sounds: 1992 proved to be a liberating experience for the UK which some have argued could be achieved on an even bigger scale by leaving the EU. The event was also significant from a policy perspective in that it marked the end of British attempts to peg the exchange rate. The ERM departure marked the third devaluation of a fixed peg, following those of 1949 and 1967. It finally proved to policymakers what many economists had said all along, that it was impossible to simultaneously operate a fixed exchange rate and an independent monetary policy whilst allowing free capital movement.

To set the scene, recall that the UK had been shadowing the DM since early 1987 in a bid to hang onto the coat tails of German policy credibility. It formally joined the ERM in October 1990 at an exchange rate of 2.95 to the DM which many people, including the Bundesbank, thought was too high. It is important also to recall that in spring 1992 Danish voters rejected the Maastricht Treaty and on 20 September, the French electorate was to due vote on the issue. European tensions were thus running high and currency markets were testing European government's commitment to maintaining their currency parities. As is now well known, sterling came under speculative pressure and the British government realised that the markets could throw more capital to attack the pound than it could muster to defend it. After a day of drama, which included a 500 bps rise in interest rates, the UK decided to leave the ERM.

Many lessons were learned that day as the recriminations began to fly. The Bank of England was disappointed that the Bundesbank did not do more to provide support. This reinforced the resistance of the policy establishment to fixed exchange rates and is one reason why the BoE came out so strongly against joining the European single currency. At the time, my view was that the debacle highlighted flaws in the ERM. The Bundesbank did not have an obligation to support ERM countries in trouble and was in any case battling with problems of its own in post reunification Germany. With hindsight, the BoE was perhaps right. The Bundesbank put its own interests first and whilst it could perhaps get away with this in the ERM, which after all was a voluntary arrangement, it raised questions about its motives, which resurfaced during the euro zone crisis of 2012. If Jens Weidmann had had his way, Greece would not have received additional aid and would surely have been ejected from the euro, which might have changed the European political landscape today.

Domestically, ERM exit changed the nature of the political debate. Conservative eurosceptics were emboldened by the lack of European cooperation to start challenging the government more aggressively on its position on EU issues. Whilst many of the political class of 1992 are no longer active in front line politics, the likes of John Redwood are still around who continues to occupy a prominent position on the right of the Conservative Party. The Chancellor in office at the time was Norman Lamont, whose career was effectively terminated by the ERM affair, and he became a trenchant EU critic who in 2016 was a prominent supporter of Brexit.

However, departure from the ERM was a liberating economic experience for the UK. It literally could take back control of its monetary policy which had effectively been subordinated to maintaining the currency parity. This allowed the BoE to cut interest rates from 10% pre-crisis to 5.25% less than 18 months later which helped to propel an economic recovery that occurred without a major pickup in domestic inflation. Not for nothing did some commentators try to portray what became known as Black Wednesday as White Wednesday.

But for those who believe that leaving the EU will prove similarly liberating, I suspect they will be disappointed. The ERM was a simple fixed exchange rate mechanism with no institutional commitments. Countries could come and go as they pleased. Indeed Italy, which also left the ERM in 1992, rejoined in 1996. Leaving the EU is a whole sight more complicated, and explains why the UK is still a member 15 months after the referendum. And unlike 1992, there has been a pickup in domestic inflation in the wake of sterling's depreciation which has proven to be very damaging to household real incomes.

That there were real benefits to be had from the ERM departure is not in dispute. Although it felt painful at the time, it hardened the UK's resolve not to join the single currency which proved to be a wise decision for a country whose currency has been devalued by two-thirds over the past century. But it also arguably heightened the belief that the UK is economically better off on its own. This is a falsehood. European monetary arrangements left a lot to be desired in 1992, and perhaps still do today. But the UK has become ever more strongly intertwined with the EU over the past 25 years, thanks to the establishment of the single market, which has largely been to its economic benefit. The lesson of 1992 is that it pays to have an independent monetary policy and that taking back control can be positive. However, as the Brexit negotiations have proven, taking back control is harder than it looks.

A brief history of currency unions

Monetary unions have a long history in international economics and we can trace them as far back as that between Phocaea and Mytilene in the late fourth or early fifth centuries BC. But it was from the late eighteenth century that formal monetary unions began to proliferate, partly as a way to consolidate political union but also to promote the conditions for cross-border trade to flourish. Two of the more successful to emerge from this period were the US monetary union which came into being with the signing of the Constitution in 1789 (which later evolved into the dollar system) and the Zollverein of 1834 which laid the foundations for German political and monetary union in the 1870s.

History suggests that the most successful monetary unions are those which encompass what we would now define as the nation state. Without getting too philosophical about it, a shared language raises the likelihood that smaller regions will find sufficient common ground to form a political union. It is therefore no surprise that the US and German monetary unions have tended to be more durable than those which have looser ties. But as the experience of Belgium and Switzerland indicates, a successful currency union can still emerge from regions which are neither nation states nor share a common language.

However, strong monetary unions tend to be based on regions with common interests, often based around language – and almost always where currency issuance is controlled centrally. Thus the nineteenth century gold standard – which met neither of these criteria – eventually collapsed. There are some similarities between the gold standard and European Monetary Union. Admittedly EMU members share common political aims, if not a language, and the system is underpinned by a central issuer of currency in the form of the European Central Bank. But in both cases member countries are linked together in a system of fixed exchange rates and have given up monetary sovereignty to one degree or another. Whilst in EMU the operation of monetary policy has been fully contracted out to the ECB, under the gold standard individual countries at least retained their own central monetary authority, although in neither case do members have monetary autonomy and both systems require economic deflation as a cure for imbalances.

The post-1945 Bretton Woods system suffered from many of the same flaws, and although it made provision for devaluations (a feature which the UK twice utilised in 1949 and 1967) it was designed to be a painful experience. One of the problems evident with the classical gold standard was (to quote John Maynard Keynes) that adjustment was “compulsory for the debtor and voluntary for the creditor.” Despite Keynes’ best efforts to eliminate asymmetric adjustments, the Bretton Woods system operated under the same principle.

Whilst EMU is different to previous cross-border monetary systems because it has a central bank which controls currency issuance and provides a centralised payments system which helps to smooth out capital needs, the fiscal rules which underpin the system highlight other deep flaws.  The Maastricht Treaty of 1992 contained a “no bailout” clause in which one country would not be held responsible for the debt of another, and these were enshrined in targets for deficits and debt relative to GDP. Not only were debt targets ignored – after all, Italy and Belgium joined when debt ratios were around 100% versus a stipulation that it should be below 60% – but the “no bailout“ clause was deeply flawed in the first place. In an integrated economy such as the EU, one country’s debts largely represent the assets of another. Consequently, the no bailout clause was never going to hold in the long-term unless the creditor countries were prepared to take a degree of pain in the event that others experienced debt problems.

Moreover, no attention was paid to external imbalances during the EMU entry process. And we should have known better, since it was external imbalances which eventually did for Bretton Woods. An economy such as Greece, which was reliant on international inflows to cover its external deficit was always vulnerable to a sentiment shift such as occurred in 2008. EMU is thus subject to the Achilles Heel of previous systems – how to manage current account imbalances in a system of fixed exchange rates. The painful truth is that we cannot unless surplus countries are prepared to recycle liquidity to finance the debt of others.

It is for this reason that the huge surpluses being built up by the likes of Germany pose such a threat to the existence of the single currency. Whilst the EU and IMF call for Germany to expand its fiscal policy in a bid to stimulate demand, and thus help to alleviate the imbalances, we may not even have to go that far. A simple recycling of the surplus by other means will suffice – perhaps via the banking sector, which after all funded the deficit countries prior to 2008. However, the European banking system is not in sufficiently good shape to perform the same role today. So if surplus countries are not prepared to loosen their fiscal stance, the EU’s warning issued earlier this year may yet come back to haunt the single currency region: “[Germany’s] persistently high current account surplus … accounts for three quarters of the euro area surplus [and] has adverse implications for the economic performance of the euro area.” As the economist Herbert Stein once warned “if something cannot go on forever, it will stop.”

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.