What a long-term weak pound means for the U.K. economy

A British one pound coin stands in this stacked photo in London, United Kingdom

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LONDON — The exchange rate of the British pound against American dollar has been on a roller coaster these past few months.

After a year of steady decline, it fell to its lowest level below $1.10 since the UK government’s infamous “mini budget” at the end of September. It then recovered to $1.16 after the country changed its finances and prime ministers in late October; and sank to $1.11 after the Bank of England downplayed expectations of a rate hike and warned that the UK had already entered its longest recession on 3 November.

The recent highs and lows have played out in a range where sterling has not traded against the greenback since 1984. In mid-2007, at the height of the financial crisis, it was possible to get two dollars to the pound. In April 2015, it was still worth $1.5; and in early 2022, $1.3.

Almost all currencies have depreciated against dollar this year and the pound’s depreciation against the euro has not been as severe given the European Union’s own challenges with the economic slowdown and energy supplies.

But the euro is still much stronger than it was against the pound in the 1990s and most of the 2000s; and the pound’s global importance has evaporated since its days as the world’s reserve currency in the early 20th century.

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A historically weaker pound over the medium to longer term has mixed impacts on the UK more broadly, economists told CNBC.

The most basic one is that imports become more expensive, while exports theoretically become more competitive.

“The problem is that the UK is very import-dependent, almost two-thirds of food is imported, so a ten per cent fall in the real effective exchange rate translates really quickly into higher food prices,” said Mark Blythe, professor of economics and public affairs. at Brown University.

“The UK is a low-wage economy. It will hurt.”

A long-term situation

Richard Ports, professor of economics at London Business School, also noted the UK’s dependence on foreign trade, meaning a “significant” impact on prices from a weaker currency, although he said there was no evidence yet of a significant effect on demand in UK for foreign goods, but not for exports, which theoretically become more competitive.

He also noted that currency depreciation has a price effect, not an inflationary one.

“It’s a one-time effect. It doesn’t necessarily give us inflation in terms of a continuous rise in the price level,” he said. “If it’s contributing to a spiral in wage prices, that’s inflation, and that’s what we’re all concerned about now.” We don’t know what to see these price increases that have occurred partly because of Ukraine and so on, we don’t know I don’t want to see wage increases that will cause prices to rise and spiral.”

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Sterling’s depreciation has been a long-term trend since it was allowed to float in 1971, he said, telling CNBC: “I think it’s reasonable to expect that to continue. And that’s partly because performance, and therefore competitiveness, hasn’t been very good compared to our trading partners. So that’s the long-term situation.”

The UK’s current account deficit (where a country imports more goods and services than it exports, and stands at £32.5bn for Britain) is being financed by capital inflows, he noted. Former Bank of England Governor Mark Carney said the UK was dependent on the “kindness of strangers”. But Ports said “it’s not their goodness, they want to invest because they find their projections and possible profits, investors find UK assets attractive enough to put in capital”.

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“If they find it less attractive, UK assets will fall in value to get people to invest more, so the exchange rate will fall further.” It depends on confidence in the British economy, fiscal policy and all that stuff.”

But, Ports said, the weaker pound is not in itself a problem for the fiscal planning the government is currently doing, with the long-awaited budget due on November 17.

“If a lot of our debt was denominated in foreign currencies, that would be the case, but it’s not. Our public debt is almost entirely denominated in pounds. So, unlike some countries, we don’t find this a problem. I don’t think the depreciation that we’ve seen or that is likely over the next few years will make much of a difference to fiscal positions.”

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“The growth model is dead”

Beyond the pain suffered by households, higher prices caused by the weaker currency will have deeper and longer-lasting effects, Blyth said.

“The UK is a highly consumption-based economy and such a change is equivalent to a consumption tax. This means less fuel in the economy engine. The UK already has low growth and even lower productivity growth.”

Potential export growth was negated by Brexit, he said, pointing out that the UK economy had shrunk from 90% to 70% the size of Germany’s since the 2016 vote.

“So what does this mean in the long run? That means the old UK growth model is dead,” Blythe continued.

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“Financing your consumption from other people’s savings (inflow of capital) and swapping overpriced houses had an expiration date. He expired. The combination of a structural depreciation of the exchange rate plus positive inflation puts an end to it.”

The appeal of cheap British assets was only sustained if they were going to be revalued, he said, and “the GBP is not the USD. Point’.

Adjusting to this new reality will be painful but necessary in the long run, Blythe believes.

“A UK that is not dependent on greater London, generating 34% of GDP, with livelihood transfers to the north and west, is a better UK. It will just take time, imagination and investment to get there.”


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