Friday 20/09/2019

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What’s next for pound sterling?

By the time the outcome of the UK referendum to leave the EU became clear, the pound sterling (GBP) started the steepest descend in 24 hours against the euro since the European single currency came into existence. Against the dollar, GBP experienced its largest two-day drop in the post-Bretton Woods era. The magnitude of the drop and the continued weakness on the back of uncertainty around Brexit demands a deeper analysis of the GBP’s outlook. In this blogpost, we focus particularly on its relationship with the euro.

 

To assess the movement in a longer term perspective, the EUR/GBP rate before the introduction of the euro in 1999 can be approximated using the European legacy currencies’ exchange rates. Such rate is of course artificial before 1999, but it might nevertheless reflect important underlying economic frictions between the two blocs that have emerged in the past.

This exercise shows us that there were several episodes when the GBP lost more than 3% in 24 hours, illustrated in the graph above. One of the first big shocks in the GBP was the devaluation of 1967 impelled by a speculative attack. After a failed attempt of European monetary cooperation in the early 70’s, the UK ended up in a currency crisis in 1976 that finished with intervention from the IMF. In the 80’s the GBP’s value was strong but volatile on the back of domestic developments (monetarist policies, the recession of the early 80’s) and external shocks (the Falkland crisis of 1982,  the increasing role of North Sea oil revenues for the UK economy). In the early 90’s, the UK joined the European exchange-rate mechanism (ERM) only to abandon it two years later in a disorderly manner, an event later known as “Black Wednesday”. The GFC and the current Brexit crisis complete the list of short term severe EUR/GBP movements.

We think there are three lessons that can be drawn from these experiences:

  • First, flexible exchange rates can be important shock absorbers of economic developments. The current account deficit of the UK is high by historical and international standards (more than 5% of GDP). The fall in GBP is currently working as an automatic adjustment mechanism for the current account. The advantage of having floating exchange rates was one of the important lessons that were learned from the crisis of ‘67 and the ERM crisis. There are, however, important differences between these crises and the current crisis: uncertainty on future trading relationships was not an issue at the time, while the independence of monetary policies is not at stake right now.
  • Second, a political crisis was often closely linked with a big event in FX markets, either as a direct consequence, a cause or both. The current GBP weakness is indeed a direct reflexion of the political impasse and related uncertainty.
  • Third, exchange rate overshooting in the short-term cannot be ruled out. This is both true for the GBP’s history as for any other floating currency. This can be explained in a classic Dornbusch overshooting framework (1976), where the degree of price stickiness of British goods and services impedes an immediate post-Brexit price adjustment. To compensate for these nominal rigidities in the short-term, the FX-rate must overshoot to reach an equilibrium.

What’s next for pound sterling after the historical Brexit fall? Various long-run equilibrium valuation attempts give mixed messages: GBP is currently trading more than 15% below its 20-year average real effective exchange rate, although there is still substantial room left for depreciation towards its PPP-level. While we cannot completely rule out overshooting in the short-term, the current account shock absorption seems the most important driver at this point. Additionally, as in past crises, it will be the political developments (more details here) that provide guidance for the GBP going forward.

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