What Brexit means for the pound

The pound sterling has depreciated against more than 120 currencies since the referendum. The prospect of leaving the European Union has adversely affected sentiment for the British currency

According to FXCM: Market Insights, the June 2016 vote in favour of Brexit created utter chaos for the British pound, comparable only to the immediate aftermath of World War II or Black Wednesday (September 16, 1992, when a collapse in the pound sterling forced Britain to withdraw from the European Exchange Rate Mechanism). Subsequently, the transition process has been a roller-coaster ride for the currency.
 
Crunch Time, an article published in The Economist (August 2018), pointed out that of 140-odd currencies tracked by the data provider Bloomberg, the pound sterling has depreciated against more than 120 currencies since the referendum. In the weeks following the Brexit referendum, the pound sterling lost 10 per cent of its value. On a trade-weighted basis, it lost 50 per cent of its value since April 2018. Its fall below $1.28 on August 10, 2018 sent it to its lowest level in a year. The prospect of leaving the European Union has adversely affected sentiment for the British currency.

 
The protagonists of Brexit, however, hold that a cheaper pound will make British products more competitive in foreign markets. While this is reflected in a seven per cent increase in exports, The Economist argues that this is due more to a general pick-up in global trade than to greater currency competitiveness. Over the same period, G7 countries have on average witnessed much stronger export growth than Britain. Considering that half of Britain’s food requirements come from overseas, the country’s import bill has gone up substantially, thanks to a weak pound. Inflation has been above the Bank of England’s target of two per cent since early 2017.  The purchasing power of working age benefits that have been frozen in cost terms until 2020 has fallen steeply.

 

Samuel Tombs of Pantheon Macroeconomics argues that in the event of no-deal Brexit, the pound will fall to $1.15, the lowest in three decades, and advises Britain to reach a sensible agreement with the EU.  
 
In its January 31, 2019 issue, The Economist noted in “Markets and Brexit: Squeal at No Deal” that the pound has risen whenever it looked like Brexit was being softened or postponed, and weakened when it looked like negotiations were deadlocked. On January 29, when a proposed amendment to postpone Brexit was defeated in the British Parliament, the pound fell by a cent against the US dollar but quickly bounced back in the hope that Britain and the EU would reach some kind of deal before the deadline of March 29 set for the departure of Britain from the EU.         

   
In the event of a no-deal Brexit, the currency markets are likely to take the biggest hit. While Adam Cole at Royal Bank of Canada anticipates a 10 per cent decline in the pound, David Page at Axa, an insurance group, expects the pound to fall to $1.10-1.15 from its current level of $1.31 and to parity with the euro, which is currently trading at 87.2 pence. David Owen at Jefferies, an American Bank, visualises a possible repeat of the pound’s mid-1980s level of $1.05.
 
While the authorities will try to limit disruption to trade that might minimise the extent of the pound’s fall, slower growth and less foreign direct investment are likely to weaken the pound. A November 2018 report of the Bank of England suggests that a no-deal Brexit would lower output but raise inflationary pressures. While the Bank of England may raise interest rates to strengthen the pound if inflation were to rise, Kallum Pickering of Berenberg, a German investment bank, observes, “Raising interest rates in the event of a hard Brexit would be the equivalent of losing a leg and deciding the best way to regain balance is chopping off the other.”               

 
Though government bonds might be risk-free, their yields will fall in the event of a no-deal Brexit. Britain badly needs foreign investment to finance its current account deficit, which was 3.9 per cent of GDP last year. David Owen thinks that investors are also worried about the possible risk of a Labour government under Jeremy Corbyn coming to power. A survey by Bank of America Merrill Lynch found that investors have never been so negative about the London market in the past 20 years. In the event of a no-deal Brexit British stocks could fall by 25 per cent and European stocks by 10 per cent, according to a forecast by the index group, MSCI.

 
Clearly, several economists are agreed that a no-deal Brexit is going to be disastrous for the pound. The British prime minister’s moves to renegotiate the deal should be seen against this backdrop. Thank God Britain while joining the European Union did not adopt the euro currency in the place of the pound!   
 

The writer was with the International Monetary Fund, Washington DC