The Pound Sterling - Why has it depreciated and what will this affect?

In the past decade the pound sterling has depreciated (a decrease in the value of a currency relative to other currencies). Although it holds the position as the world's 5th strongest currency, following its sudden and rapid falls in values, the strength of the pound is coming into question. Recent geopolitical events, such as Brexit, Covid and Russia’s invasion of Ukraine and the government’s inability to pay off its debt have all caused significant changes in the value of the pound and with inflation at a 40 year high people are wondering what has caused the pound to fall in value and what effects it has had.

In 2016 the United Kingdom voted to leave the European Union. Arguably, the most significant element of Brexit was the UK losing out on the trade agreement it had with the EU. This meant the UK left the single market and no longer had access to free trade with the EU. Free Trade is an agreement where the exchange of goods and services between nations is not restricted or hindered by tariffs and quotas. By leaving the single market, the UK gave up its right to free trade and as result trade between countries in the EU had to be renegotiated. Considering over half of the UK's 10 biggest trading partners in 2016 were EU countries - according to the office for national statistics - this is damaging for the UK, as trade with the EU is now subject to custom duties (a charge on goods sent to the UK from abroad). Although the EU and UK Trade and Cooperation Agreement establishes zero tariffs or quotas, this only applies to products that meet the relevant rules of origin. Overall, despite the trade agreement met between the EU and the UK, there is much more friction in trade as a result of the increase in bureaucracy and costs.

Key Currency reports since Brexit the exchange rate between the Pound Sterling and Euro has been £1 for a range of €1.10 – €1.20. Before Brexit the average exchange rate was £1 for €1.31. The key factor determining the depreciation of the Pound to the Euro was a fall in confidence for the Pound. Investors believed the increased friction in trade would make investment in the UK riskier resulting in an inward shift of demand for the Pound, which consequently caused depreciation.

(Credit: Xe Historical Currency Exchange Rates Chart)

A depreciation in the pound is damaging to the UK as it makes imports more expensive, resulting in a fall in purchasing power for consumers in the UK. The House of Commons Library reported in 2020 that 50% of imports were from the European Union, highlighting how important trade with the EU and raising the question was leaving the EU the right thing to do? Undoubtedly, a depreciation in the exchange rate has benefitted UK exports, as exports are now cheaper making the UK more competitive in the global market and considering the UK runs a persistent current account deficit an increase in exports would be advantageous as it could contribute to a balanced current account. However it is important to mention that many businesses in the UK have moved their distribution headquarters to EU nations, so they can continue to act within the framework of the single market such as Hampstead Tea Company as reported by the Financial Times. Not only does this highlight the perceived benefits of a depreciation are not being met, but also that businesses have lost confidence in investing and operating in the UK and therefore demand for the pound has fallen meaning in current circumstances it is unlikely the pound will return to its pre-brexit value.

In September this year Kwasi Kwarteng announced the mini budget with an ambitious aim for economic growth (the rise in GDP overtime) of 2.5%. This was to be achieved through cutting taxes to increase purchasing power, and increase the incentives for greater production and productivity. The highest band of income tax was to be abolished, there was going to be a cut in stamp duty and corporation tax was to stay at 19%. On top of this, to protect consumers from rising energy bills, annual energy bills were to be capped at £2,500 with the government paying the excess amount. In order to fund such ambition £100 billion were to be taken out in loans.

Three days after the announcement the pound sterling fell to its lowest value on record at £1 for $1.0697 USD on 26 Sep 2022. The primary reason for the depreciation was a supply shock caused by the dumping of UK government bonds on the market. Investors holding government bonds completely lost faith in the government’s ability to off its debt (which is approximately equivalent to 98% of the uk's GDP), as the Treasury announced a fiscal hole of £60bn. The problem was exacerbated as investors had lost confidence the government could pay off its debt resulting in a fall in demand for government bonds, which consequently caused a fall in the demand for pounds, depreciating the exchange rate.

Although the pound did appreciate, this was not due to an increase in confidence but rather an intervention by the Bank of England who started buying bonds in an attempt to prevent the value of bonds falling more. The Bank of England also increased the base interest rate, which now sits at 3%. Increasing interest rates increases demand for the Pound Sterling as it encourages businesses, consumers and investors to save money. As there’s a higher return many people began buying pounds to save seeking the increased reward from saving.

The most significant effect of the disastrous mini budget was it caused a fall in confidence for investors in the UK because it increased political instability, opened an unfunded fiscal hole, and put into question the UK's ability to pay back the national debt. It is likely, therefore, there will be less investment in the UK and a further weakening of the Pound as the perceived risk of investing in the UK increases, which will ultimately hinder economic growth.

A huge issue facing the UK at the moment is the rate of inflation (the rise in the general price level overtime), which the office for national statistics (ONS) calculated to be 13.2% in September 2022, 11.2% above the target inflation rate of 2%. The most significant reasons for the unprecedented inflation rate (which has hit a 40 year high), are rising energy bills and disruptions in supply chains, which have been largely caused by COVID-19 and Russia’s invasion of Ukraine.

As a result of COVID-19 precautions in 2020, such as lockdowns, social distancing and self isolation, the UK economy shrunk by 9.9% according to the ONS. The fall in GDP was caused by a decrease in aggregate demand creating spare capacity, where factors of production were not used to their full potential. Once restrictions were eased, the objective of the UK government was economic growth, which was to be achieved by demand management. Schemes, such as the Furlough Scheme and Eat Out Help Out, increased consumption in the economy resulting in an increase in GDP as aggregate demand increased. Aggregate demand has exceeded the equilibrium creating an excess in demand, which has put upward pressure on prices, causing inflation. The greatest problem caused by covid was a huge disruption in supply chains, creating large and significant bottlenecks. This caused a supply shock and cost push inflation.

Although during the lockdown the Pound appreciated to the US Dollar, from May 2021 the Pound has depreciated. This is reportedly due to confidence falling as doubts in the UK’s ability to recover from COVID increase.

In 2021 the ONS reported that 24.1% of refined oil, 5.9% of crude oil and 4.9% of natural gas imported the UK are from Russia; since Russia’s invasion of Ukraine began these imports have fallen by 100% as shown in figure 3.

This has put huge upwards pressure on energy prices as there's an excess in demand, fuelling inflation.

The UK imports 7.3% of all food in the UK from Ukraine (according to ONS). With the disruption in supply lines and a fall in the factors of production producing food in Ukraine, food prices in the UK are rapidly increasing, once again due to excess demand.

The largest consequence of inflation, as a result of the war in Ukraine, is a fall in purchasing power as inflation is greater than the increase in wages. This issue is further intensified as, although the exchange rates stay the same, currencies with a lower inflation than the UK see their currency appreciation to the pound and the pound depreciate to their currency such as the US Dollar where the Guardian reports inflation rates to be 7.7% in October 2022. This means imports to the UK are getting more expensive, which is particularly harmful as 42% of all food in the UK is imported and 50% of gas used in generating energy is imported, which is escalating inflation in the UK. It is no surprise CNBC forecasts inflation to hit over 22% in 2023.

The UK maintains the world's spot as the 5th strongest currency, however a fall in confidence from Brexit, Covid and Kwasi Kwarteng’s mini budget have caused an inward shift in demand causing a depreciation in the pound which is unlikely to recover. Furthermore, the 40 year high inflation rate is depreciating the value of the pound further increasing the price of imports which the UK heavily relies on. This has caused a fall in the purchasing power of economic actors, putting the UK in a precarious situation.

Sources

The Pound Sterling - Why has it depreciated and what will this affect?

Recent Posts

Comments