As the pound has risen more than 20 per cent in real effective terms over the last one year, more and more analysts are drawing parallels to the 1979-81 period. During that period too the pound had appreciated by a similar percentage and British industry became so uncompetitive that almost one-fifth of the manufacturing sector was wiped out. Is history likely to repeat itself? Before addressing the question, lets look at the similarities. Indeed, at that time, the sharp rise in oil prices was one important trigger for the soaring pound, given Britains oil exports from the North Sea. The other was high interest rates "" the base rate was around 16 per cent in 1981. Rising interest rates have certainly helped the pounds appreciation in recent months. It may be recalled that, in the run-up to the election, the erstwhile Tory Chancellor had resisted the central banks demands for raising interest rates to cool off a booming economy and soaring consumer demand. As soon as Labour came in power, the new Chancellor made two far-reaching policy decisions as far as the Bank of England (BoE) is concerned "" he delegated full powers to the Bank for setting interest rates, and also announced his intention to divest the central bank of its supervisory duties. The BoE has already raised the Base Rate four times in the last few months. The last hike undertaken on 7 August has, perversely enough, led to some weakening of the pound.
To be sure, the pounds rise started well before the recent actions on interest rates. For almost four years after the withdrawal of the currency from the exchange rate mechanism of the European Monetary System and its sharp fall, the exchange rate had ruled fairly, indeed unusually, steady. Against the dollar, the sterling was ranging between $ 1.50 - 1.60, and in the more important mark terms between DEM 2.25 - 2.50. One hardly recalls a parallel period of equally low volatility against both the currencies.
In the last one year, the situation has changed dramatically. The pound suddenly became a darling of the foreign exchange markets on prospects of higher interest rates and the mark getting subsumed in a weak euro. Almost in a straight line, the pound moved from DEM 2.30 to DEM 3.08 at one stage. Recently it seems to have stabilised around the DEM 3.00 level. This represents a 30 per cent rise against European currencies in just one year. Against the dollar too the rise was sharp "" from $1.55 a year back to $1.71 at the beginning of this year, since when it has ruled generally well above the $ 1.60 level ($ 1.59 last Friday morning).
Even at current exchange rates, The Economist estimates that U.K.s unit
labour costs are two-thirds of Germanys and four-fifth of Japans. Thus, predictably, it sees nothing to worry about the competitiveness of British industry. Others have different views, particularly captains of manufacturing industry. British Steel has already had to cut jobs as it is no longer competitive in the European market. The chairman of British Steel recently argued that at an exchange rate in excess of DEM 2.50/60, industry is just not competitive. So far at least exports have not suffered much in terms of actual performance. The reason seems to be that an increasing percentage of exports is not very price sensitive; for those that are, exporters are cutting margins in order not to lose market share, in the hope that the exchange rate will become more favourable sooner rather than later.
One effect of the volatility in the exchange rate has been that British industry is seeing more and more clearly the virtues of participating in the single European currency. To be sure, industry was always more inclined towards EMU than the eurosceptic politicians, particularly the Tories. Now, this demand is becoming more vociferous as the rising pound has started hitting industry where it hurts most "" on the bottom line. The top industry lobby, the Confederation of British Industry (CBI), recently urged the government to make an early pledge to join EMU. While Labour is far more positive and friendly towards Europe than the jingoistic Tories, CBIs prayers are unlikely to be answered soon. Prime Minister Blair and his Chancellor would probably prefer to sit on the fence for some more time. The pledge to join EMU, if made, would surely be the fastest way to weaken the pound given the current weak euro fashion in the markets.
One major factor that could affect the balance of trade is consumer spending, currently growing at its fastest rate in 10 years. Part of the reason for the spending boom is the corporatisation of a number of building societies in the U.K. In the past year or so, many of them have been converted into limited companies. The erstwhile members of the societies have been issued shares worth an estimated 35 billion pounds. This has suddenly put a vast amount of money in the hands of the average consumer, leading to the rapid rise in spending. The exchange rate has also made imports cheaper. Historically, a rise in consumer spending on imported goods has been the cause of rising trade deficit in the U.K. This may happen once again.
Chances are therefore that while the pound, buoyed by interest differentials, may remain strong in European currency terms for some time as a safe haven from the expected euro-turmoil, sooner or later the exchange rate might get pulled down by the wider trade deficit, even if the currency remains outside the EMU.
I have referred above to be proposed divestiture of the Bank of Englands supervisory functions over the banking industry. The Newro, as the new unified supervisory authority for all financial markets is likely to be called, will take over the supervisory responsibilities of the Securities and Investments Board (SIB), the various self regulatory organisations (SROs) for different segments of the financial services industry, and the Bank of England. It is envisaged that this will take place in stages over the next two years.