The level of the pound exchange rate has been the subject of many debates in and outside the U.K. since the June 23 Brexit referendum. And understandably so: the British currency has lost 17.3% between Jan. 1 and Oct. 21 this year against the euro and about the same against the U.S. dollar. Strikingly, sterling's weakening has been viewed as either very positive or very bad news. For the Brexiteers who view the U.K.'s forthcoming exit from the EU as positive, the pound's correction was long overdue and removes a major obstacle to stronger growth for the country's industry as a whole. For the Remainers, by contrast, the lower currency is the harbinger of higher inflation and lower purchasing power. We would be tempted to argue that both sides have some valid arguments, although not over the same timespan. But we will avoid taking too noncommittal a view, remembering former Prime Minister Margaret Thatcher's famous quip: "Find me an economist with only one hand!"
- The British pound has fallen sharply in value against the euro and the dollar following the U.K. decision to leave the EU.
- The growing importance of the U.K. financial services industry, particularly in the period 2000-2007, pushed the pound's exchange rate well above its equilibrium value.
- Fundamental economic methodologies suggest that the pound's exchange rate is now undervalued by perhaps as much as 15%.
- We believe the Bank of England's monetary policy will aim to keep the pound close to its current levels over the medium term to sustain growth prospects.
The Pound As A Commodity Currency
The core argument of those welcoming the pound's recent correction is that its exchange rate had been unduly influenced by the weight of the U.K.'s financial services industry, at the expense of other sectors. The former governor of the Bank of England was reported as making this point in June in New York, stating that the fall in sterling was "a welcome change" that has generated "reactions which are over the top". In a recent column, Paul Krugman brought back to the fore a theory that had previously been applied to commodity-producing economies, such as Russia ("Notes on Brexit and the pound," New York Times, Oct. 11, 2016). His argument in summary is that, following Mrs. Thatcher's Big Bang and the subsequent rise in the City, the British economy has been experiencing a version of so-called Dutch disease. This term refers to the crisis that took place in the Netherlands following discoveries of vast natural gas deposits in the North Sea Groningen field in 1959. The new-found wealth and massive exports of gas caused the Dutch guilder to rise sharply, making exports of all non-gas products less competitive on the world markets. By analogy, the boom in the City's financial exports that followed the deregulation of financial markets after October 1986 (the Big Bang) acted in the same way: they crowded out manufacturing exports by pushing the currency up. The recent exchange rate decline reflects the adjustment that the U.K. financial industry will have to undergo following Brexit. The separation from the EU means that it will face substantially higher transaction costs, while some institutions will feel incentivized to transfer some of their operations to mainland Europe. To offset higher costs and make London a still very attractive financial center will require a weaker currency. An additional benefit of this adjustment is that it could help to rebalance the U.K. growth model away from a "single commodity" economy towards a more diversified one, in which manufacturing becomes more competitive again.
This explanation is undoubtedly attractive. It helps understand why the majority of the Brexit votes were in regions where the manufacturing and agricultural sectors had been predominant, and supposedly penalized by a strong pound. It also echoes the Brexiteers' claim that the City had acquired too much clout and needed to be reined in. Even more importantly, it leads its proponents to reject the notion of an equilibrium rate for sterling: if indeed the pound exchange rate was primarily acting as a "natural resource currency" because of the share of the City in recent decades, there is no point in trying to estimate what its equilibrium rate should be, as history becomes of no value since it was distorted. This is where things become more complicated, in our view. The Dutch disease story has some currency (no pun intended) but it does not entirely fit the pound's recent market trends.
The Pound As A Very Volatile Currency
The pound is accustomed to large swings in its nominal exchange rate. Since 1975, the pound experienced eight major periods of decline. On average, those episodes lasted six months, with the pound losing 13.8% against the dollar and 18% against the euro. The pound's biggest drop against the greenback was in 1981 and again in 1982 (19% each time). Looking at the past 36 years, (charts 1-A and 1-B) it appears that the period when sterling enjoyed relative stability at a fairly strong level, considering its effective exchange rate, was between 1998 and 2007.
The pound strengthened at the end of the 1990s, well after the deregulation of the financial sector from 1986 onward, suggesting that the influence of the City as a major exporter, as described in the "Dutch disease" narrative, took time to materialize. On the other hand, 1998-1999 are not coincidental dates. They correspond to the launch of the euro and the establishment of the European monetary union (EMU). In that sense, as London became the EMU's main capital market a number of financial institutions established themselves or increased their operations in the U.K. significantly, bidding up the pound exchange rate. We would therefore argue that the City's influence on the pound, as described above, makes for a valid explanation especially if related to the creation of the EMU. A highly deregulated and competitive financial center, the City, with direct access to the single monetary union (passporting rights) was the key driver of the pound's strengthening. But why then did the pound fall so sharply in 2008 against the euro and the U.S. dollar?
The Pound As A Competitive Tool
The City's connection with the EMU had a major influence on the pound exchange rate from 1999 onward, but monetary policy continued to play a key role as well. The influence of monetary policy decisions on the currency has probably been more effective in the case of sterling than other major developed economies in the past decades. The 500 bps cut in the Bank of England's (BoE's) policy rate between 2007 and 2009 produced the desired effect of weakening the pound against all other major currencies at a time when world trade was slowing dramatically. Previous episodes of sudden swings in the exchange rate can also be related to monetary policy shifts.
Sterling's recent slide can be viewed as the result of the BoE's monetary policy easing--aimed at protecting the economy from the negative effects of Brexit on growth. The City's economic influence is not going to vanish in one day. On the other hand, its access to the EMU, a key driver of its overall blossoming after 1999, will critically depend on the outcome of the negotiations between the U.K. and the EU. Assuming that the City's influence on sterling was a temporary factor (17 years) in a long history of ups and downs, brings us back to the fundamental question: what's sterling's equilibrium rate? In other words, how much lower is it likely to go before it finds a floor?
The Pound's Economic Fundamentals
Assessing the equilibrium level of the exchange rate of the pound can help us evaluate the degree of misalignment of the current exchange rate compared to its fundamental value. There is a variety of concepts of equilibrium exchange rates in academic literature. They are usually based on the comparison of relative prices between the countries, and/or are related to a country's external balances (the current account and net foreign asset position).
One approach is the Purchasing Power Parity (PPP). In its absolute form, the PPP hypothesis states that the exchange rate between the currencies of two countries should equal the ratio of the price levels of the two countries. In other words, £100 in the U.K. should buy as much as £100 exchanged into U.S. dollars and used to purchase goods in the U.S.
The PPP exchange rate of the pound has been relatively stable over the past two decades, standing at about $1.44 to the pound sterling (see chart 3), according to the data published in the IMF World Economic Outlook. This computation suggests that the pound has been at its equilibrium level during four different periods since 1990: in Q2 1994, in 2001-2002, in Q1 2009, and in Q2 2016, while it has reached its highest overvaluation level in Q4 2007 (more than 40% misalignment). We note that the pound's overvaluation was particularly striking over the period 2000-2007 when, as noted above, the City's influence (the "Dutch disease") was rising.
At its current level of $1.22 (as of Oct. 26) to the pound, the PPP methodology implies that the pound is undervalued by as much as 15%.
However, the PPP approach does not take into account the differences in the productivity levels between the countries. While prices of tradable goods that are subject to international competition are expected to be equalized across countries, this is not the case for non-tradables, such as domestic services. In fact, the Balassa-Samuelson effect suggests that countries with higher productivity levels should have higher prices of non-tradables. Therefore, the equilibrium exchange rate should reflect the differences in productivity levels. Besides, the PPP method doesn't address medium-term concerns about external imbalances. This is why another approach to equilibrium exchange rates focuses on the requirement for achieving external balance over time. Indeed, persistent sizable current account imbalances are presumed not to be able to last forever, and it is therefore assumed that an adjustment in exchange rate is needed at some point.
The U.K. has been running a current account deficit for more than three decades, but it has widened significantly in recent years (see chart 4), reaching £100 billion in 2015, the second-largest in the world after the U.S. In relative terms, the U.K. current account deficit was the largest among the group of advanced economies in 2015, at 5.4% of GDP. The current account gap reached 5.8% in the first half of 2016. The major reason for the growing current account deficit has been a marked deterioration in the U.K. income balance over recent years. This reflects to a large extent a decline in earnings on U.K. investment abroad (in particular in the euro area). At the same time, the trade balance remained relatively stable over the past few years. The balance on trade in goods has been persistently negative (-6.7% of GDP in 2015), which has been partially offset by the surpluses in trade in services (4.8% of GDP in 2015).
From the external balance perspective, persistent and widening current account deficits suggest that the pound was overvalued in the years before the June referendum, and a correction was likely inevitable at some point. Currency depreciation should help improve the trade balance, by making U.K. products more attractive to foreign buyers, while reducing demand for imports. Importantly, it should also have a positive effect on the income balance. This is because more of the U.K.'s external assets than liabilities are denominated in foreign currency. Therefore, other things equal, a weaker currency boosts investment income from U.K. overseas assets in pound terms, while there is a smaller negative effect on the liabilities side.
Has the post-referendum depreciation been sufficient to restore the medium-term balance? The answer to this question requires an assessment of the level of the U.K. equilibrium current account, i.e. the current account linked to medium-term macroeconomic fundamentals, such as the relative growth rate, the fiscal balance, and demographic factors that affect savings decisions, among others. The next step would be to estimate the required exchange rate adjustment needed to achieve the equilibrium current account.
In its Article IV report published in June, the IMF estimated the equilibrium current account for the U.K. at -0.6% of GDP. After adjusting for likely temporary effects of the recent deterioration in the income balance, the IMF estimates the real effective exchange rate of the pound was overvalued by 12% in 2015. This implies that following post-referendum depreciation, the pound became undervalued by about 7%.
We also note the assessment by Oxford Economics that uses the BEER (Behavioural Equilibrium Exchange Rate) approach to estimate the equilibrium exchange rate. The equilibrium real effective exchange rate in this method depends on relative productivity and net foreign assets as a percentage of GDP. According to Oxford Economics estimates, a long-run fair value of the pound post-Brexit is around $1.47 per pound. This is broadly similar to the equilibrium exchange rate based on PPP.
The Bank Of England's Dilemma
If these estimates are accurate, the BoE will soon be presented with a difficult choice. Headline inflation is unavoidably going to accelerate beyond the bank's official target of 2% in the coming quarters as a result of higher import prices. At the same time, the country's growth prospects have weakened. Addressing the former requires tightening policies--and a stronger pound--while the latter pleads for the opposite. Past experience suggests that the bank may choose to focus on inflation expectations, rather than on inflation itself. If markets perceive this acceleration as simply a temporary blip, the BoE may be able to avoid tightening its monetary policy stance as long as the EU-U.K. negotiations continue.
So, is the pound currently undervalued? During the first decade of this century the growing importance of the financial services industry undoubtedly pushed the pound's exchange rate away from its equilibrium value, whether measured in PPP terms or with respect to the external balance. The recent decline in the U.K. currency can be attributed both to expectations that the City's weight in the economy will decline somewhat over time as a result of Brexit, and to vigorous actions taken by the BoE to soften Brexit's impact on near-term economic growth. Fundamental economic methodologies used to establish an equilibrium exchange rate--be they related to relative prices or the external balance--consistently suggest that the pound's exchange rate is now undervalued by perhaps as much as 15%. Part of this undervaluation is due to the overshooting that inevitably happens during correction phases. Whether the undervaluation persists or not is going to depend on the BoE's next moves. Based on past experience, especially in 2007-2009, we would expect that the BoE will choose to see through the rising inflation and focus on mid-term economic growth prospects. If, as our review suggests, the pound is now meaningfully undervalued, it will remain so for quite some time.