The governor, the markets and the tumbling pound

Sterling’s sudden plunge is a reflection of greater concerns about the UK economy

It started with an innocuous-sounding article in the Bank of England’s quarterly bulletin, published last Monday. Called Interpreting Recent Movements in Sterling, it looked at why the pound had fallen so much in the past two years.

One reason, it suggested, was the perception in the markets that Britain’s economy would be more seriously affected by the global financial crisis than those of other countries.

The more the markets became concerned about risk, the deeper their concern about sterling; the pound to an extent became a proxy for the state of nervousness in the markets.

It was another reason the Bank advanced for the pound’s weakness, however, that grabbed the attention of the markets. Britain had, since the 1990s, run a deficit on its balance of payments’ current account averaging 2% of gross domestic product.

This was fine as long as capital flowed into Britain from other countries, which it did. Britain’s banks borrowed from the international markets and lent into the UK economy. The end of that process, however, could mean a fall in “the long-run sustainable real exchange rate” for the pound.

Sterling fell on reports of the article, dropping below 1.10 against the euro. It staged a small recovery in the middle of the week, when minutes of the Bank’s monetary policy committee meeting earlier this month showed, contrary to speculation, that there had been no discussion of a cut in the interest rate on commercial bank reserves.

An interview on Thursday with Mervyn King then sent it down again. The governor, interviewed by The Journal, a Newcastle newspaper that is running a campaign to boost exports, said rebalancing the British economy was “very necessary” and that “the fall in the exchange rate that we have seen will be helpful to that process”.

The effect was to give currency traders another excuse to sell, pushing the pound below 1.09 against the euro and under $1.60 on Friday. Sterling’s all-time low against the euro was 1.02, at the end of last year but in June it climbed above 1.18.

“If you look at when sterling has made its big moves over the past couple of months, and ask ‘who has been saying what to whom?’, most of these moves are linked to the Bank,” said Simon Derrick, senior currency strategist at Bank of New York Mellon.

The markets were spooked by news that King and two colleagues had pushed to increase the amount of so-called quantitative easing to £200 billion, and by hints from him of a cut in the interest rate on some commercial bank reserves.

But Derrick and other analysts cautioned against concluding that King was trying to talk the pound down.

Peter Dixon, an economist with Commerzbank, said: “It is evident that he was referring to the fall in the exchange rate which has already occurred and merely repeating the message which the Bank has been giving through much of this year, that a weaker currency can only be of benefit to an economy which is in dire need of a boost.

“His comments could be interpreted as a policy of benign neglect towards the currency — one could almost call it indifference — but that is very different from actively talking down the pound, particularly since the Bank showed similar indifference when sterling was rising.”

Whether the Bank is to blame or not, the effects of the pound’s sharp moves have already been significant for business. Last summer, Jonathan Bellwood took a big gamble. The sudden fall in the value of the pound was making business much more expensive for PeopleVox, the stock-control technology company he had started just three months earlier in High Wycombe.

Prices of the components PeopleVox was importing from America had shot up by 26% in just a few months so Bellwood decided that the company would make the equipment in the Midlands.

“You naturally look to eastern Europe or the Far East but we found a big pool of talent in central England,” Bellwood said. “Their proximity was key because it meant it was quicker to bring products to market.”

Not only that, but the strengthening of the euro against the pound suddenly presented an opportunity to export to the larger European market. Instead of focusing on a UK customer base, the company switched focus almost overnight and the gamble paid off.

“There we were worrying about the recession when actually there was this great opportunity on our doorstep,” said Bellwood. Turnover will have reached almost £1m by the end of the year and 80% of customers will be international. Bellwood says being a small company has been a great advantage because it was much easier to adapt to the swings in the exchange rate. “The big beasts wouldn’t be able to do that,” he said.While the pound’s fall is providing a boost for exporters like Bellwood — though most overseas markets remain weak — it is bad news for importers.

“In the short-run the fall in the pound boosts exports but it also puts upward pressure on the prices of the many things, such as electrical and electronic goods, that Britain imports,” said the British Retail Consortium. “Together with the coming increase in Vat back to 17.5%, this will increase shop price inflation.”

The BRC also pointed out that the weak pound will increase food price inflation, both through the direct effect on the price of imports but also by increasing the incentive for farmers to sell abroad rather than in the UK, thereby creating potential supply shortages.

Jonathan Pincas started his business, The Tapas Lunch Company, four years ago. The idea was simple. He would buy Spanish food — chorizo, Spanish ham, manchego cheese and anchovies — direct from Spain and sell to specialist restaurants in the UK.

When he started, the exchange rate was between €1.40 and €1.50 to the pound. As the pound weakened, Pincas began to realise that this could be a big problem for his small company. When sterling fell to just above parity with the euro last Christmas, his fear became a reality. “It has been awful for us,” he said. “We sell direct to restaurants, pubs and caterers and they are extremely price-sensitive. They couldn’t care less about currency exchange. All they care about is the price and if we increase it, they’ll go elsewhere so the burden stays with us.” Pincas is unsure whether his fledgling business will survive. “The margins are pressed so tight that we have questioned whether we should continue,” he said. “If the pound strengthened it would give us a new lease of life. No other factor could make such a dramatic difference.”

Nick James would also love a rise in the pound. As managing director of Pol Roger in the UK, his role involves importing the eponymous champagne and the Joseph Drouhin burgundy. In the boom, champagne consumption soared and the pound went from strength to strength.

The good times ended last year. “It was extremely difficult,” he said.

“Obviously we were hedged on currency fluctuations but you can only buy that in tranches of three to four months so we were caught short when it fell to parity at the end of last year,” he said. The most painful aspect of this was not being able to offer his customers any stability on prices.

“Normally we hold our prices for a year but that was impossible in 2008. This spring we put prices up and we have held them there until now but it looks as if we might have to re-address pricing again.”

Though business may have to get used to some further turbulence, not everybody is gloomy about the pound’s prospects. Barclays Capital, in a new set of currency forecasts published on Friday, predicted a rise for sterling against the euro to €1.18 in three months’ time and 1.25 this time next year. Against the dollar it expects a rise to $1.80.

Paul Robinson, Barclays Capital’s sterling strategist, said the bank’s optimism was based on its belief that the global economy would recover more strongly than the markets expect, reducing the need for a lower pound to rebalance the economy. It also believes that many currency traders have misunderstood the Bank’s stance.

A big reason behind its view of sterling strength, however, is that it thinks the Bank could begin to raise interest rates as early as next February. Robinson said: “We believe the threat of losing credibility means that the Bank cannot appear to allow inflation to remain persistently high and we think it is the central bank most likely to surprise the markets.” (David Smith, The Sunday Times)


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