The pound has fallen to its lowest rate against the euro since July 2013 and the lowest rate against the US dollar since 1985. Since August 2015, the pound has depreciated by 23.4% against the euro and 22.2% against the dollar. And since the referendum of 23 June, it has depreciated by 15.6% against the euro and 17.6% against the dollar.
On Sunday 2 October, at the start of the Conservative Party conference, the Prime Minister announced that Article 50, which triggers the Brexit process, would be invoked by the end of March 2017. Worries about what the terms of Brexit would look like put further pressure on the pound: the next day it fell by around 1% and the next day by a further 0.5%.
Then, on 6 October, it was reported that President Hollande was demanding tough Brexit negotiations and the pound dropped significantly further. By 7 October, it was trading at around €1.10 and $1.22. At airports, currency exchange agencies were offering less than €1 per £ (see picture).
With the government implying that Brexit might involve leaving the Single Market, the pound continued falling. On 12 October, the trade-weighted index reached its lowest level since the index was introduced in 1980: below its trough in the depth of the 2008 financial crisis and below the 1993 trough following Britain’s ejection from the European Exchange Rate Mechanism in September 1992.
So just why has the pound fallen so much, both before and after the Brexit vote? (Click here for a PowerPoint of the chart.) And what are the implications for the economy?
The articles explore the reasons for the depreciation. Central to these are the effects on the balance of payments from a possible decline in inward investment, lower interest rates leading to a net outflow of currency on the financial account, and stimulus measures, both fiscal and monetary, leading to higher imports.
Worries about the economy were occurring before the Brexit vote and this helped to push sterling down in late 2015 and early 2016, as you can see in the chart. This article from The Telegraph of 14 June 2016 explains why.
Despite the short-run effects on the UK economy of the Brexit vote not being as bad as some had predicted, worries remain about the longer-term effects. And these worries are compounded by uncertainty over the Brexit terms.
A lower sterling exchange rate reduces the foreign currency price of UK exports and increases the sterling price of imports. Depending on price elasticities of demand, this should improve the current account of the balance of payments.
These trade effects will help to boost the economy and go some way to countering the fall in investment as businesses, uncertain over the terms of Brexit, hold back on investment in the UK.
Articles
Pound Nears Three-Decade Low as May Sets Date for Brexit Trigger Bloomberg, Netty Idayu Ismail and Charlotte Ryan (3/10/16)
Sterling near 31-year low against dollar as May sets Brexit start dat Financial Times, Michael Hunter and Roger Blitz (3/10/16)
Sterling hits three-year low against the euro over Brexit worries The Guardian, Katie Allen (3/10/16)
Pound sterling value drops as Theresa May signals ‘hard Brexit’ at Tory conference Independent, Zlata Rodionova (3/10/16)
Pound falls as Theresa May indicates Brexit date BBC News (3/10/16)
The pound bombs and stocks explode over fears of a ‘hard Brexit’ Business Insider UK, Oscar Williams-Grut (3/10/16)
Pound Will Feel Pain as Brexit Clock Ticks Faster Wall Street Journal, Richard Barley (3/10/16)
British Pound to Euro Exchange Rate’s Brexit Breakdown Slows After Positive Manufacturing PMI Halts Decline Currency Watch, Joaquin Monfort (3/10/16)
7 ways the fall in the value of the pound affects us all Independent (4/10/16)
The pound and the fury: Brexit is making Britons poorer, and meaner The Economist, ‘Timekeeper’ (11/10/16)
Is the pound headed for parity v US dollar and euro? Sydney Morning Herald, Jessica Sier (5/10/16)
Flash crash sees the pound gyrate in Asian trading BBC News (7/10/16)
Flash crash hits pound after Hollande remarks Deutsche Welle (7/10/16)
Sterling mayhem gives glimpse into future Reuters, Swaha Pattanaik (7/10/16)
Sterling takes a pounding The Economist, Buttonwood (7/10/16)
Government must commit to fundamental reform The Telegraph, Andrew Sentance (7/10/16)
Data
Interest & exchange rates data – Statistical Interactive Database Bank of England
Questions
- Why has sterling depreciated? Use a demand and supply diagram to illustrate your argument.
- What has determined the size of this depreciation?
- What is meant by the risk premium of holding sterling?
- To what extent has the weaker pound contributed to the better economic performance than was expected immediately after the Brexit vote?
- What factors will determine the value of sterling over the coming months?
- Who gain and who lose from a lower exchange rate?
- What is likely to happen to inflation over the coming months? Explain and consider the implications for monetary and fiscal policy.
- What is a ‘flash crash’. Why was there a flash crash in sterling on Asian markets on 7 October 2016? Is such a flash crash in sterling likely to occur again?
In a recent blog, Falling sterling – bad for some; good for others, we looked at the depreciation of sterling following the Brexit vote. We saw how it will have beneficial effects for some, such as exporters, and adverse effects for others, such as consumers having to pay a higher price for imports and foreign holidays. The article linked below examines these effects in more depth.
Just how much the quantity of exports will increase depends on two main things. The first is the amount by which the foreign currency price falls. This depends on what exporters choose to do. Say the pound falls from €1.30 to €1.18. Do exporters who had previously sold a product selling in the UK for £100 and in the eurozone for €130, now reduce the euro price to €118? Or do they put it down by less – say, to €125, thereby earning £105.93 (£(125/1.18)). Their sales would increase by less, but their profit margin would rise.
The second is the foreign currency price elasticity of demand for exports in the foreign markets. The more elastic it is, the more exports will rise for any given euro price reduction.
It is similar with imports. How much the sales of these fall depends again on two main things. The first is the amount by which the importing companies are prepared to raise sterling prices. Again assume that the pound falls from €1.30 to €1.18 – in other words, the euro rises from 76.92p (£1/1.3) to 84.75p (£1/1.18). What happens to the price of an import to the UK from the eurozone whose euro price is €100? Does the importer raise the price from £76.92 to £84.75, or by less than that, being prepared to accept a smaller profit margin?
The second is the sterling price elasticity of demand for imports in the UK. The more elastic it is, the more imports will fall and, probably, the more the importer will be prepared to limit the sterling price increase.
The article also looks at the effect on aggregate demand. As we saw in the previous blog, a depreciation boosts aggregate demand by increasing exports and curbing imports. The effects of this rise in aggregate demand depends on the degree of slack in the economy and the extent, therefore, that (a) exporters and those producing import substitutes can respond in terms of high production and employment and (b) other sectors can produce more as multiplier effects play out.
Finally, the article looks at the effect of the depreciation of sterling on asset prices. UK assets will be worth less in foreign currency terms; foreign assets will be worth more in sterling. Just how much the prices of internationally traded assets, such as shares and some property, will change depends, again, on their price elasticities of demand. In terms of assets, there has been a gain to UK balance sheets from the depreciation. As Roger Bootle says:
Whereas the overwhelming majority of the UK’s liabilities to foreigners are denominated in sterling, the overwhelming bulk of our assets abroad are denominated in foreign currency. So the lower pound has raised the sterling value of our overseas assets while leaving the sterling value of our liabilities more or less unchanged.
Article
How a lower pound will help us to escape cloud cuckoo land, The Telegraph, Roger Bootle (31/7/16)
Questions
- What determines the amount that exporters from the UK adjust the foreign currency price of their exports following a depreciation of sterling?
- What determines the amount by which importers to the UK adjust the sterling price of their products following a depreciation of sterling?
- What determines the amount by which sterling will depreciate over the coming months?
- Distinguish between stabilising and destabilising speculation? How does this apply to exchange rates and what determines the likelihood of there being destabilising speculation against sterling exchange rates?
- How is UK inflation likely to be affected by a depreciation of sterling?
- Why does Roger Bootle believe that the UK has been living in ‘cloud cuckoo land’ with respect to exchange rates?
- Why has the UK managed to sustain a large current account deficit over so many years?
Since the Brexit vote in the referendum, sterling has been falling. It is now at a 31-year low against the US dollar. From 23 June to 6 July it depreciated by 12.9% against the US dollar, 10.7% against the euro and 17.0% against the yen. The trade-weighted sterling exchange rate index depreciated by 11.6%.
Why has this happened? Partly it reflects a decline in confidence in the UK economy by investors; partly it is in response to policy measures, actual and anticipated, by the Bank of England.
As far as investors are concerned, the anticipation is that there will be net direct investment outflows from the UK. This is because some companies in the UK are considering relocating part or all of their business from the UK to elsewhere in Europe. For example, EasyJet is drawing up plans to move its headquarters to continental Europe. It is also because investors believe that foreign direct investment in the UK is likely to fall as companies prefer to invest elsewhere, such as Ireland or Germany.
Thus although the effect of net direct investment outflows (or reductions in net inflows) will be on the long-term investment part of the financial account of the balance of payments, the immediate effect is felt on the short-term financial flows part of the account as investors anticipate such moves and the consequent fall in sterling.
As far as monetary policy is concerned, the fall in sterling is in response to four things announced or signalled by Mark Carney at recent news conferences (see Monetary and fiscal policies – a U-turn or keeping the economy on track?).
First is the anticipated fall in Bank Rate at the next meeting of the Monetary Policy Committee on 13/14 July. Second is the possibility of further quantitative easing (QE). Third is an additional £250bn of liquidity that the Bank is prepared to provide through its normal open-market operations. Fourth is the easing of capital requirements on banks (reducing the countercyclical buffer from 0.5% to 0%), which would allow additional lending by banks of up to £150bn.
Lower interest rates, additional liquidity and further QE would all increase the supply of sterling on the foreign exchange markets. The anticipation of this, plus the anticipation of lower interest rates, would decrease the demand for sterling. The effect of these supply and demand changes is a fall in the exchange rate.
But is a fall in the exchange rate a ‘good thing’? As far as consumers are concerned, the answer is no. Imports will be more expensive, as will foreign holidays. People’s pounds will buy less of things priced in foreign currency and thus people will be poorer.
As far as exporters are concerned, however, the foreign currency they earn will exchange into more pounds than before. Their sterling revenues, therefore, are likely to increase. They might also choose to reduce the foreign currency price of exports, thereby increasing the quantity sold – the amount depending on the price elasticity of demand. The increase in exports and reduction in imports will help to reduce the current account deficit and also boost aggregate demand.
Articles
Pound slumps to 31-year low following Brexit vote The Guardian, Katie Allen , Jill Treanor and Simon Goodley (24/6/16)
Sterling’s post-Brexit fall is biggest loss in a hard currency Reuters, Jamie McGeever (7/7/16)
Brexit Accelerates the British Pound’s 100 Years of Debasement Bloomberg, Simon Kennedy and Lukanyo Mnyanda (5/7/16)
Pound sterling falls below $1.31 hitting new 31-year low Independent, Hazel Sheffield (5/7/16)
Viewpoints: How low will sterling go? BBC News, Leisha Chi (6/7/16)
How low will the pound fall? Financial Times (7/7/16)
Allianz’s El-Erian says UK must urgently get its act together or dollar parity could beckon Reuters, Guy Faulconbridge (7/7/16)
What does a falling pound mean for the British economy? The Telegraph, Peter Spence (6/7/16)
Data
Spot exchange rates: Statistical Interactive Database – interest & exchange rates data Bank of England
Questions
- What determines how much the exchange rate depreciates for a given shift in the demand for sterling or the supply of sterling?
- Why might the short-term effects on exchange rates of the Brexit vote be different from the long-term effects?
- Why has the pound depreciated by different amounts against different currencies?
- What are likely to be the effects on the financial and current accounts of the balance of payments of the Bank of England’s measures?
- Find out what has happened to business confidence since the Brexit vote. What effect does the level of confidence have on the exchange rate and why?
In recent months the Chinese central bank (the People’s Bank of China) has taken a number of measures to boost aggregate demand and arrest the slowing economic growth rate. Such measures have included quantitative easing, cuts in interest rates, a devaluation of the yuan and daily injections of liquidity through open-market operations. It has now announced that from 1 March it will reduce the reserve requirement ratio (RRR) for banks by a half percentage point.
The RRR is the percentage of liabilities that banks are required to hold in the form of cash reserves – money that could otherwise have been used for lending. This latest move will bring the compulsory ratio for the larger banks down from 17.5% to 17%. This may sound like only a small reduction, but it will release some ¥650bn to ¥690bn (around $100bn) of reserves that can be used for lending.
The cut from 17.5% to 17% is the fourth this year. Throughout 2014 and 2015 it was stable at 20%.
The hope is that this lending will not only help to boost economic growth but also stimulate demand for the consumption of services. The measure can thus be seen as part of a broader strategy as the authorities seek to re-balance the economy away from its reliance on basic manufacturing towards a more diversified economy. It is also hoped that the extra demand will help to boost jobs and thus provide more opportunities for people laid off from traditional manufacturing industries.
It is expected that further reductions in the RRR will be announced later in the year – perhaps a further 1.5 to 2 percentage points.
But what will be the effect of the releasing of reserves? Will the boost be confined to $100bn or will there be a money multiplier effect? It is certainly hoped by the authorities that this will stimulate the process of credit creation. But how much credit is created depends not just on banks’ willingness to lend, but also on the demand for credit. And that depends very much on expectations about future rates of economic growth.
One issue that concerns both the Chinese and overseas competitors is the effect of the measure on the exchange rate. By increasing the money supply, the measure will put downward pressure on the exchange rate as it will boost the demand for imports.
The Chinese authorities have been intervening in the foreign exchange market to arrest a fall in the yuan (¥) because of worries about capital outflows from China. The yuan was devalued by 2.9% in August 2015 from approximately ¥1 = ¢16.11 to approximately ¥1 = ¢15.64 (see chart) and after a modest rally in November 2015 it began falling again, with the Chinese authorities being unwilling to support it at the November rate. By January 2016, it had fallen a further 2.8% to approximately ¢15.20 (click here for a PowerPoint file of the chart).
But despite the possible downward pressure on the yuan from the cut in the reserve requirement, it will probably put less downward pressure than a cut in interest rates. This is because an interest rate cut has a bigger effect on capital outflows as it directly reduces the return on deposits in China. The central bank had already cut its benchmark 1-year lending rate from 6% to 4.35% between November 2014 and October 2015 and seems reluctant at the current time to cut it further.
China central bank resumes easing cycle to cushion reform pain Reuters, Pete Sweeney (29/2/16)
China cuts reserve requirements for banks to boost economy PressTV (29/2/16)
China Moves to Bolster Lending by Easing Banks’ Reserve Ratio New York Times, Neil Gough (29/2/16)
Economists React: China’s ‘Surprise’ Bank Reserve Cut Wall Street Journal (29/2/16)
China Cuts Banks’ Reserve Requirement Ratio Bloomberg, Enda Curran (29/2/16)
China Reserve-Ratio Cut Signals Growth Is Priority Over Yuan Bloomberg, Andrew Lynch (29/2/16)
China reserve ratio cut not a signal of impending large-scale stimulus: Xinhua Reuters, Samuel Shen and John Ruwitch (2/3/16)
China injects cash to boost growth and counter capital outflows Financial Times, Gabriel Wildau (29/2/16)
China’s Economic Policy Akin To Pushing On A String Seeking Alpha, Bruce Wilds (2/3/16)
China cuts banks’ reserve ratio for fifth time in a year: Why and what’s next Channel NewsAsia, Tang See Kit, (1/3/16)
Questions
- Explain what is mean by the required reserve ratio (RRR).
- Explain how credit creation takes place.
- What will determine the amount of credit creation that will take place as a result of the $100bn of reserves in Chinese banks released for lending by the cut in the RRR from 17.5% to 17%.
- What prompted the recent cuts in the RRR?
- Why may China’s recent monetary policy measures be like pushing on a string?
- Is the reduction in the RRR a purely demand-side measure, or will it have supply-side consequences?
- Explain how different types of monetary policy affect the exchange rate.
- Should other countries welcome the cut in China’s RRR? Explain.
In the blog Japan’s interesting monetary policy as deflation fears grow we detailed the aggressive monetary measures of Japan’s central bank to prevent a deflationary mindset becoming again established. In January it introduced a negative interest rate on some deposits placed with it by commercial banks. This is in addition to it massive quantitative easing programme to boost the country’s money supply. Despite this, the latest consumer price inflation data show inflation now running at zero per cent.
As the chart shows, since the mid 1990s there have been protracted periods of Japanese price deflation (click here to download a PowerPoint file of the chart). In January 2013 Japan introduced a 2 per cent CPI inflation target. This was accompanied by a massive expansion of its quantitative easing programme, through purchases of government bonds from investors.
Following this substantial monetary loosening, buoyed too by a loosening of fiscal policy, the rate of inflation rose. It reached 3.7 per cent in May 2014.
However, through 2015 the rate of inflation began to fall sharply, partly the result of falling commodity prices, especially oil. The latest inflation data show that the annual rate of CPI inflation in January 2016 fell to zero percent. In other words, consumer prices were on average at the levels seen in January 2015.
The latest inflation numbers appear give further credence to the fear of the Bank of Japan that deflation is set to return. The introduction of a negative deposit rate was the latest move to prevent deflation. As well as encouraging banks to lend, the move is intended to affect expectations of inflation. By adopting such an aggressive monetary stance the central bank is looking to prevent a deflationary mindset becoming re-established. Hence, by increasing the expectations of the inflation rate and by raising wage demands the inflation rate will rise.
The loosening of monetary policy through a negative interest rate follows the acceleration
of the quantitative easing programme announced in October 2015 to conduct Open Market Operations so as to increase the monetary base annually by ¥80 trillion.
The decline of Japan’s inflation rate to zero may yet mean that further monetary loosening might be called for. Eradicating a deflationary mindset is proving incredibly difficult. Where next for Japan’s monetary authorities?
Data
Consumer Price Index Statistics Bureau of Japan
New Articles
Japan’s inflation drops to zero in January MarketWatch, Takashi Nakamichi (25/2/16)
Japan inflation falls back to zero in January: govt AFP (26/2/16)
With pause in inflation, many brace for retreat Nikkei Asian Review (27/2/16)
Japan’s inflation rate has fallen again – to 0% Business Insider Australia, David Scutt (26/2/16)
Previous Articles
Bank of Japan adopts negative interest rate policy CNBC, Nyshka Chandran (29/1/16)
Japan adopts negative interest rate in surprise move BBC News (29/1/16)
Bank of Japan shocks markets by adopting negative interest rates The Guardian, Justin McCurry (29/1/16)
Japan stuns markets by slashing interests rates into negative territory The Telegraph, Mehreen Khan (29/1/16)
Japan introduces negative interest rate to boost economy The Herald, (29/1/16)
Questions
- What is deflation?
- What are the dangers of deflation? Why is the Bank of Japan keen to avoid expectations of deflation becoming re-established?
- To what extent are national policy-makers able to exert pressure over the rate of inflation?
- What does a negative interest rate on deposits mean for depositors?
- What effect is the Bank of Japan hoping that a negative deposit rate will have on the Japanese economy? How would such effects be expected to occur?
- What effect might the Bank of Japan’s actions be expected to have on the structure of interest rates in the economy?
- How might the negative interest rate effect how people wish to hold their wealth?
