Is the fall in sterling good or bad news?
Mon, Sep 28 2009, 11:17 GMT
by Lloyds TSB Financial Markets Economic Research Team
Judging by the fevered headlines surrounding the fall in the UK’s exchange rate over the past couple of weeks, one might imagine that sterling was on the verge of a currency crisis. We argue that it is not. We examine the reasons for the recent decline in the UK currency and assess its prospects going forward. Our conclusion is that, far from being a cause for concern, the depreciation is not only desirable, but essential if the UK is to undergo a successful rebalancing away from domestic demand towards net exports over the coming years. Indeed, judging by the comments made by Bank of England Governor Mervyn King last week, and a recent article published in its latest Quarterly Bulletin, this view appears to be shared by the Bank of England.
Are the recent movements in sterling really that large?
Firstly, it is worth assessing whether recent movements justify some of the hyperbole in the press. We do not believe so. Since early September, sterling’s trade-weighted index has fallen by around 4.5%, primarily pulled lower by a 4% drop against the US dollar, a 5% fall against the euro and a 5.5% fall against the yen. Although the recent falls have been relatively large, they are not unusual for a historically volatile currency such as sterling. To put the recent decline into perspective, the average one-month standard deviation of the UK’s trade-weighted index over the past five years has been 2.2%; for £/$, £/ € and £/Y it has been 3.3%, 2.4% and 4.9%, respectively.
Is sterling undervalued?
The latest decline brings the cumulative depreciation of sterling’s trade-weighted index to 26% since it hit a peak in January 2007. Nonetheless, contrary to conventional wisdom, the UK currency does not appear to be particularly undervalued at current levels, at least against the major currencies. Table 1 shows some key statistics of the major sterling crosses in both nominal and real terms. In nominal terms, sterling is only 3% away from its average value against the US dollar since the early 1990s, well below one standard deviation from its mean. Against the euro and yen, however, the undervaluation appears more substantial, with £/€ and £/Y 1.8 and 1.4 standard deviations below their 1990-2009 means, respectively. On the face of it, this suggests that sterling could be due a bounce against these currencies. But, when account is taken of the relative movements in consumer prices, these undervaluations disappear.
The reason for this is the divergence that has occurred in relative consumer prices since the early 1990s. In the UK, the price level has risen faster than it has in the eurozone and Japan. Other things being equal, the rise in prices has made the UK economy less competitive as sterling’s real exchange rate has strengthened. The shift has been particularly noticeable versus the yen, given Japan’s deflation over the past decade. Against the yen, sterling is currently slightly above its average in real terms.
Sterling is susceptible to further weakness…
The fact that sterling’s real value against these crosses does not appear particularly stretched suggests that there is clearly scope for sterling to fall further. Indeed, we suspect the fall in sterling’s nominal and real exchange rate over the past couple of years has done little more than reverse what was previously an unsustainable overvalued position (see chart a). Indeed, given the UK’s persistent current account deficit, the conclusion is, perhaps, that sterling has not fallen enough.
Looking ahead, there are a number of reasons to believe that sterling may continue to weaken. Firstly, the UK has lagged, and is likely to continue to lag, the global economic recovery – see chart b. This underperformance may partly be structural, related to the high level of UK private sector indebtedness, and the relatively larger role financial services have traditionally played in the UK. As a result, a weaker currency may be required to boost growth. Second, it is likely that UK interest rates may remain lower for longer than those in many other countries, thus weakening the relative returns on sterling assets. Third, public sector net borrowing in the UK has risen far more sharply than in other countries over recent years – see chart c - implying a real exchange rate depreciation.
All these factors appear to help explain the recent fall in sterling. More fundamentally, as the Bank of England suggests in its latest Bulletin, they may have been responsible for a reduction in sterling’s long-run sustainable value. Given that sterling’s real exchange rate is not particularly undervalued, the correction in sterling is likely to have further to go, albeit erratically, before finding a new equilibirum.
Fall in sterling essential for a successful rebalancing of the UK economy
Indeed, the adjustment is part of a necessary rebalancing of the UK away from domestic demand towards net trade. But for the UK economy to successfully rebalance over the coming years, not only will the exchange rate need to fall further, but domestic demand in other countries will also need to recover. China is a case in point. Policies currently being pursued there are aimed at stimulating domestic demand and reducing their country’s reliance on net exports.
The UK economy has much to gain from an opening of China’s markets and a recovery in export markets elsewhere. Judging by the improvement in some global leading indicators, such as the Baltic Dry Index, global trade volumes are beginning to rise again, see chart d. If the UK economy can face into the improvement in global growth with a competitive exchange rate, the prospects of a successful rebalancing of the UK economy would be substantially enhanced. We believe it can do, with a further fall in sterling a pre-requisite. As chart e shows, we expect net exports to contribute more to UK gdp growth over the coming years.
