Pound recovers but remains at low levels – how to assess the long-term value of sterling
The pound has recovered from a recent record plunge following the Chancellor’s mini-budget announcement. But it’s still at low levels compared to many other currencies.
The latest decline is mainly due to the tax cuts announced during Chancellor Kwasi Kwarteng’s recent mini-budget. The £45bn package raised concerns among investors as it significantly increased future public debt, although Kwarteng has since announced a U-turn on £2bn plans to end cuts for the highest earners. More generally, escalating inflationary expectations due to this increased fiscal expansion combined with persistently rising energy costs are having a negative impact on the UK economy and hence the value of sterling.
The weakening of the pound is also part of a global phenomenon. The US dollar has appreciated by 12% against a broad currency index and by more than 20% against the pound since the end of 2021. This broad appreciation is attributed to a tightening of US monetary policy and a shift in investor risk appetite towards US dollar assets, which are currently viewed more as a safe haven asset.
Given these underlying pressures, there are many questions about sterling’s long-term valuation, including whether it will settle at par with the US dollar. Analysis by Bloomberg has shown that financial markets believe sterling has a 60% chance of reaching dollar parity by the end of 2022. Price inflation.
If policymakers are to shore up the currency’s strength, several economic theories suggest they need to address high inflation expectations, the impact of Brexit and the various supply chain issues currently plaguing the economy.
Compare burgers to burgers
Ever heard of the Big Mac Index? Research on long-term exchange rate movements shows that in many countries they tend to change in line with relative rates of inflation. Known as Purchasing Power Parity (PPP), this theory uses the price of certain products or baskets of goods to compare currencies and living standards in different countries.
As such, we can examine the value of the pound relative to other currencies by looking at a single product, such as a McDonald’s Big Mac burger. Since this product is the same in all countries, the Big Mac can be used to calculate an implied PPP exchange rate by comparing the UK and US price. In July 2022, the Big Mac Index showed the pound to be undervalued by around 14% based on the exchange rate implied by Big Mac prices in the US versus the UK.
Bank of England projections put inflation at 14% by the fourth quarter of 2022, but it is expected to fall to 5% by the end of 2023. The relative decline in UK inflation in 2023 should strengthen the pound and reduce the projected undervaluation according to the Big Mac index.
KULLAPONG PARCHERAT / Shutterstock
Another theory that can help us understand the long-term value of the pound is the relationship between sovereign debt sustainability, sovereign risk and exchange rates. A sharp increase in the ratio of government debt to gross domestic product (GDP) may trigger a weakening of the currency as financial markets anticipate greater risk, i.e.
Before World War II, when sterling was the world’s reserve currency, the government could borrow money cheaply. However, today’s sterling no longer enjoys the same privileges, particularly in recent weeks when sterling has been compared even to emerging market currencies. This theory would dictate that for sterling to regain value, the debt-to-GDP ratio and corresponding sovereign risk would have to fall.
Long-term exchange rate movements can also be assessed by comparing differences in productivity across countries. Known as the Balassa-Samuelson hypothesis, this theory links productivity declines in a country’s tradable sector – the industries that produce goods that are traded internationally – to a weakening of the real exchange rate (ie after accounting for inflation differentials).
This theory would therefore link supply chain disruptions resulting from Brexit and the war in Ukraine to a fundamental decline in UK productivity, leading to a long-term depreciation of the pound.
Protect the pound
Rescuing the pound from long-term parity with the dollar will require action by policymakers. The Bank of England oversees monetary policy – including using interest rates to manage the money supply to the economy – and is mandated by the government to fight price stability by using interest rate hikes to lower inflation. Futures markets are forecasting a rate hike from 4% to 6.25% by May 2023, showing the expectation that the bank will continue to raise rates to fight inflation.
The government handles fiscal policy – spending and tax decisions – and recommendations from markets and organizations such as the International Monetary Fund point to the need for more prudence and fiscal restraint amid current inflationary pressures. The UK government will announce a medium-term fiscal plan on November 23 that should aim to address the public debt-to-GDP ratio and boost investor confidence in the economy.
Read more: Why IMF comments on the UK economy have scared traders and investors
Perhaps the most difficult challenge, however, will be managing structural change as a result of the recent productivity slowdown due to Brexit and pandemic-related supply chain disruptions. Easing post-Brexit trade relations with the European Union could provide the UK tradables sector with the support it needs to boost sterling.
Without firm plans on these issues, the prospects for the long-term valuation of the pound remain uncertain. While global factors such as investor risk appetite may continue to keep the dollar strong, domestic factors may moderate these effects. Monetary tightening, fiscal consolidation and structural reforms in the trade sector will all contribute to a revaluation of the pound and provide a way for policymakers to shore up its value on the international stage.