Understanding Sterling Weakness
by George Hatjoullis
I went away for few days of sun (while I can still afford it). In my absence the UK formally declared xenophobia a government policy and compromised the independence of the Bank of England. Sterling collapsed but what is most astonishing is that ‘people’ seem surprised that sterling collapsed. Let me attempt to clarify.
The xenophobic stance of the government means a so called ‘hard’ Brexit is inevitable, if the UK chooses to invoke article 50. The PM says she will do this by March 31, 2017 (which means the UK will leave the EU by April 1, 2019). A hard Brexit means the UK will leave the single market and then need to renegotiate its trade and access relationships after 2019. There is no way to know what the UK can achieve at this point. The exit process does not necessarily involve negotiation of relationships with the EU and whilst still a member of the EU, the UK cannot negotiate new relationships. The exit period is a dead period from a negotiation perspective though the UK retains single market access. The government may not grasp this. The Leavers may not grasp this. The markets certainly do!
Losing access to the single market means tariffs and non-tariff trade barriers will confront the UK that are not there now. One way to offset this is to regain competitiveness through currency depreciation. Ultimately, perhaps new deals will compensate. However, new access deals are a long way off and uncertain. The only certainty is the loss of existing preferential access to a 500m very wealthy market after April 1, 2019. Sterling weakness is discounting this loss and the uncertainty that surrounds what the UK can recover after this date. Sterling has a fundamental bias to weakness that dates back to June 24, 2016.
The prime minister has also sought to directly address monetary policy. This has been seen as compromising the independence of the BoE. Markets do not like this! Moreover, the intention is populist and has the reinforced the impression that the UK government is committed to populism irrespective of the economic cost. This kind of behaviour is often seen in what we colloquially know as banana republics. The comments on foreign (non-British) workers are even more reflective of this populist direction. Corporations are being directed (nudged) to abandon the practice of seeking and hiring the best candidates for the business and only to do so subject a local hiring constraint. Populism at an economic price also gives Sterling a bias to weakness. A weaker currency is required to offset this labour market restriction.
The currency markets are not very subtle. If a currency develops a bias to weakness then selling it comes to be seen as a one way bet. The market momentum takes over and there is a bias to sell. No one is thinking about the price at which all this is discounted because no one knows what it is. The bias to sell remains until either the currency is very obviously too cheap whatever happens or the fundamental bias to weakness is eliminated (failure to exit, better than expected trade deals etc). In the meantime Sterling will be subject flash crashes as the bias to sell hits illiquidity and will almost certainly overshoot on the downside.
Does all this matter? There are redistribution consequences to Sterling weakness and they will matter to the winners and losers. There will be a one off inflation impulse. This could translate into a wage/price spiral if the labour market is distorted by government policy. The most serious consequence of the combined effect of all these developments however may be to discourage direct investment in the UK in the medium term. Interestingly there is a scenario in which all the emphasis on migration and local jobs reduces the employment prospects of the local work force.
The UK could become best suited for high value added, high productivity industries. These industries employ relatively few people compared to turnover and value added and have very highly skilled workers. It will be much easier to justify high skilled foreign workers in this new xenophobic environment and the fewer total workers required the better. The local skilled workforce might also seem cheap, being paid in Sterling to produce things that earn ‘hard’ currency. The unintended consequences of Brexit may be the loss of mass low to medium skill jobs.
One thing I can say with confidence is Sterling would have been StrongerIN.