Is the pound’s fall really bad news?

The movements in the pound are headline news, with the currency’s big drop widely interpreted as a sign of bad times ahead for the UK. However, things may not be as grim as they seem.

Pound sterling and dollar notes
Source: Bloomberg

Back in 2014, the IMF warned that the pound was overvalued, and was preventing the UK from shifting towards an economy that was less reliant on consumer spending and imports. The Fund suggested that the currency was around 5-10% more expensive than economic fundamentals should warrant.

Admittedly, since then the pound has declined against the dollar by a lot more than 10%. With the move from a pre-Brexit vote high to the current low below $1.22 being about 18%, the move is rather dramatic to say the least.

Indeed, it was the common opinion of many economists, including former Bank of England governor Mervyn (now Lord) King, who has recently said that the devaluation will help cushion the UK economy from any Brexit shock, while also helping to boost inflation and thus get the BoE closer to its target.

Even Deutsche Bank suggested back in December 2015 that the pound could fall to $1.15 as the Federal Reserve raised rates while the Bank of England held monetary policy at its (then) current loose setting (a view that likely did not take into account the possibility of a vote to leave the EU).

There were dire predictions about the UK economy in advance of Brexit – it was suggested that the UK economy would immediately tip into recession, with a stark drop in domestic demand and a sudden capital flight from the UK. So far, none of that has come to pass. Indeed, as a result of the fall in sterling we may enjoy the benefits of cheaper exports, while the current account deficit falls as imports become more expensive.

In point of fact, the UK has just undergone, in a matter of months, what the Bank of Japan and the European Central Bank have been trying to achieve for years (in Japan’s case, decades), namely the weakening of the currency in order to boost economic growth. The ECB’s easing has reduced the Real Effective Exchange Rate (REER) for the eurozone, helping to lift economic growth; those with high external deficits have been particular beneficiaries.

As the chart below shows, the drop in the pound since Brexit has meant that the currency is now back towards its longer-term average. The Japanese have been enjoying the benefits of an undervalued currency for some time now, while the eurozone is also seeing its currency remain cheap versus key competitors:

Previous devaluations, in 1992, when the UK left the ERM, and in 1931 when it left the gold standard, prompted a sustained rise in prosperity for the UK. Perhaps it is not too far-fetched to hope that a similar situation will prevail here. As the global economy grows in coming months, UK exporters should be in a prime position to take advantage of the cheap currency to boost revenues, improving the UK’s balance of payments.

The sharp drops in sterling have been a shock. It would have been preferable for the currency to decline steadily, providing greater visibility. But we are where we are; it is time to look to the future with a degree of optimism, knowing that a weaker pound will prove a boon for the British economy. 

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