Brexit: Weighing the costs of a lighter pound
Sterling’s fall has led to fears over a drop in demand and profits. Can higher exports compensate?
Everywhere Stephen Glancey looks, he finds Brexit and the sharp fall in the pound clouding his view. The chief executive of C&C Group, the makers of Magners cider and Tennent’s lager, makes half its revenues in sterling but its profits are reported in euros. Those “will take a dip”, he says.
Worse, he is worried that the weaker pound could leave customers with less money to spend on cider and beer. “There are signs the consumer has been holding back on spending since the referendum,” says Mr Glancey.
C&C’s currency worries illustrate the unsettling effects of Brexit and the resulting downward pressure on the pound. Companies say they are having to rip up their plans as consumer demand seems to have stalled. Some worry this spells recession for the UK.
It is a far different scenario the UK finds itself in than just over a fortnight ago. In the trading hour after polls closed on referendum night, sterling peaked at $1.50, its highest level since December, as pollsters pointed to a victory for the Remain camp.
The shock victory for Leave was felt in the immediate aftermath as foreign exchange traders rushed to sell the pound, graphically described this week by Bank of England governor Mark Carney as the “largest two-day fall against the dollar since floating exchange rates were reintroduced almost half a century ago”.
A rally in sterling at the end of last week seemed to steady the markets. “There was the sense that we had the shock, but people were talking about the UK not actually exiting the EU, about Article 50 [the mechanism that starts the process to leave the EU] not being triggered,” says Bilal Hafeez, currency strategist at Nomura.
But market fears returned this week and the pound resumed its decline, keeping it at 30-year lows close to $1.30. And its weakness has already done damage: Standard Life’s real estate fund was the first of a procession to freeze redemptions this week, and companies like C&C began to warn of the after-effects from sterling’s slide.
“This week felt like the week when sterling was really going to impact on the economy,” Mr Hafeez says.
Sudden currency moves tend to be the preserve of politically unstable developing economies. The joke among some foreign exchange analysts was that the basket of emerging markets currencies — a group that includes Brazil, Russia, Turkey and South Africa — would soon be welcoming a new member.
The sharp decline in the pound, while widely forecast as a potential consequence of Brexit, recalls previous precipitous falls in the currency.
George Magnus, senior economic adviser at UBS, notes that major devaluations of the pound were “the norm” in the era before the 1944 Bretton Woods system of fixed exchange rates. In the 1980s, the oil price crash brought sterling close to parity with the dollar, and sterling plummeted again after the UK’s 1992 exit from Europe’s exchange rate mechanism. Most recently, it fell sharply after the 2008 financial crisis.
During many of those earlier devaluations, the weaker pound reinforced, or fed, the notion that the country itself was in decline. For those worried about the consequences of Brexit on the UK economy, the post-referendum 13 per cent decline in sterling against the dollar is just a foretaste of what is to come.
“The market is a voting machine, and everybody is voting against the UK economy,” says Mr Hafeez.
Some Brexiters argue that a weak pound will be beneficial to the UK, helping domestic businesses sell more goods abroad and improving Britain’s balance of payments. Andrea Leadsom, the pro-Leave candidate for the Conservative party leadership, says a weaker pound was “good for exports and it makes inward investment more attractive. It means we may import less and buy more at home.
These are all good things for our economy.”
Despite Mr Glancey’s other currency woes, he does see benefits for his Scottish export business. “We have had a number of enquiries in the last 10 days to export beer,” he says, noting that European competitors should now find selling into the UK tougher.
Sterling’s weakness will certainly have other economies looking on with envy. In a global economy of low growth and low interest rates, a weaker exchange rate promises competitive trading advantages. But deliberate targeting of the exchange rate, in a move associated with “currency wars”, is now frowned on by the US and other G20 countries following their agreement in February to refrain from competitive devaluation. The UK has achieved it through the unwanted shock of Brexit.
A weaker pound proved desirable in the aftermath of the 1992 ERM debacle, Mr Magnus says.
Interest rates were cut and sterling’s fall helped improve the UK’s balance of payments, spurring a recovery. What was dubbed “Black Wednesday” was later modified to “White Wednesday” by some economists.
“The doom-and-gloom prognosis turned out to be crying over spilled milk,” he says. But Mr Magnus adds that the early 1990s was an era when sterling was already overvalued, China was emerging as a global world power, the IT boom was under way and the world was emerging from recession.
“They were very different times which bear no resemblance to the current situation,” says Mr Magnus.
The current situation is one in which the UK finds one of its big structural weaknesses, its current account deficit, suddenly exposed by sterling’s fall, raising questions about the country’s capacity to continue to attract capital to help pay down the interest on that chronic debt.
Sterling is a good case study in the problem of running persistent deficits over long periods of time, says Matthew Cobon, fund manager at Columbia Threadneedle. “Sterling benefited a lot during the European crisis as a destination for safe-haven capital. It had also been one of the best European economies from a headline growth perspective in recent years,” he says.
“When these financial flows go quickly into reverse, the emperor is discovered to have no clothes.”
Mr Carney is preparing to reveal how he can mitigate Brexit’s impact, with a rate cut looking likely. But most market commentators think the BoE will be unable to stem the pound’s decline.
On top of the deficit problem are worries about the UK’s access to exports markets, says Paul Lambert, head of currency at Insight Investment. “This is a potentially catastrophic position for the pound and the reason why we believe that most of the adjustment is likely to be in front of us and not behind us,” Mr Lambert says.
One key to understanding the pros and cons of a falling pound is to establish what is motivating its fall.
“If property funds are being liquidated and UK banks are declining massively, it’s a reflection of higher risk in the UK,” says Mr Hafeez. “But if it’s a reflection of the Bank of England easing policy and the UK economy slowing, that’s a good decline.”
The only thing that is certain at present is uncertainty, and that is enough for currency strategists to revise down their sterling forecasts. The pound fell by 29 per cent in 1992-93 and by a third in 2007-08, so similar plunges would take the currency to between $1.13 and $1.22.
But Mr Magnus and Mohamed El-Erian, chief economic adviser at Allianz, both go so far as to say that it was possible sterling could decline to parity with the dollar — uncharted territory.
Much depends on the UK’s Brexit negotiations with the EU, says Mr El-Erian. “If the UK secures a comprehensive new free trade arrangement for goods and services, current levels will look very cheap,” he says. “If, however, such an arrangement lags behind or is not comprehensive enough, then current levels would be seen as the new normal for sterling.”
Companies are having to adjust rapidly to a new era of sterling devaluation. One that is ahead of the game is Gear4Music, an online instrument retailer, which sells in eight currencies.
Sterling’s decline allowed it to knock down the price of an electric guitar from €130 pre-Brexit to €119. The result, says chief executive Andrew Wass, has been a big spike in European sales since the vote. “Brexit made us pretty competitive overnight,” says Mr Wass.
As Mr Glancey is finding at C&C, there are pros and cons to sterling’s big move. Gear4Music buys some of its products in dollars, while two-thirds of its sales are in the UK.
The way to manage sterling’s convulsions is to react quickly to change. “I’m not worried. We have a very multicurrency business,” says Mr Wass.
A flexible and nimble approach to Brexit is the recipe many believe the UK government needs in its negotiations with the EU. Those are precisely the ingredients that companies will need as the pound tumbles, but the outlook is treacherous.
“The pound may get low enough, or UK assets may get cheap enough, that foreigners will want to buy them again,” says Mr Lambert. “But that journey is likely to involve a much weaker domestic economy. Ultimately, the country will have to decide whether that is a price worth paying.”