Is Pound Sterling on a free fall?

Embed from Getty Images

As the Brexit referendum result was streamed in live globally on June 23, the UK currency started to slide against all major currencies.  After a few days of heavy selling, the Pound stabilized and indeed started to rebound as a result of bargain hunting.  Inevitably though, reality started to set in once again as it continued its downward trend.  As of now, it is already 15 percent lower than its previous peak before Brexit, thus equalling its single biggest drop when the UK exited the Exchange Rate Mechanism (ERM) in 1992.  The relevant question now is whether renowned currency speculator George Soros’ prediction of a 20 percent fall for the Pound will in fact come true, or will it bounce back and rally to a quick recovery?

Embed from Getty Images

Here are several possible factors to consider.

UK-EU trade deal.  This must be the biggest question on everyone’s mind – whether or not the British government can successfully broker a trade deal with the EU that will not disrupt the present UK-EU trading relationship.  This in turn depends on whether or not London will accept the continued free movement of people between the UK and the continent across the English Channel in return for continued preferential trade arrangement, or will the British public remind their government of fact that the Brexit referendum outcome was precisely based on the premise that the free movement of people into the UK should be stopped, period.  In the end, it is highly unlikely that any British government (however pro-European) will go against the wishes of the majority, and hence will end up rejecting any trade deal offer by Brussels that still includes the unfettered free movement of people into the UK.  And it needs to be remembered that complete free movements of goods and people are so central to the idea of the European Union that it is inconceivable that Brussels will give any exception to any EU member economy no matter how important they are, and that includes Germany and France too.  As compromise is not likely, the UK will have no other option but to trigger Article 50 of the Lisbon Treaty, and hence set in motion a complete break away within a two-year time frame.  Any further delay will unnecessarily prolong the agony of commercial uncertainty facing the business community in the UK and abroad.  A zero trade deal with the EU will result in a free fall of the Pound.

Fiscal policy.  In the event that the present uncertainty continues to affect the decisions of private investors in the UK, as it looks likely, the British government will have no other option than to reverse its fiscal consolidation target and shelve all pre-Brexit austerity plans.  Calls for Keynesian-style government intervention are already sounded out from various quarters, hence it will be natural for the government to heed their calls, lest that it will lose in the next general elections!  This will in turn worsen the already quite high public debt of the UK, hence triggering further downgrade by international credit rating agencies.  The likely outcome will almost certainly be a hike in borrowing costs that will further add to the hesitancy of foreign direct investment (FDI) into the UK.  This will in turn worsen the already quite high accumulated current account deficit of the UK, which will definitely impact on the exchange rate market, specifically weakening the Pound further.

Interest rate.  Already the Bank of England (BoE) Governor Mike Carney restated several times that all bets are off as far as hiking the UK interest rate is concerned, as the UK economy is now experiencing an “economic post-traumatic stress disorder” in the words of Carney.  As the balance sheet situation of UK banks has never been healthier since the 2008 financial crisis, it is only natural that the banking sector will not want to be an obstacle to what has now turned into a catastrophy prevention on a national scale.  This will entail the BoE implementing a combination of lower interest rate (from the present 0.5 percent) and increased money supply, both aimed at encouraging credit growth in the hope that consumers and businesses will pick up the signal and start spending.  Whether or not this will succeed is another issue, but the loosened monetary policy pursued will inevitably make the Pound a less attractive currency on the exchange rate market.

Comments welcomed.