When the Bank of England governor, Mark Carney, said that the UK was reliant on the kindness of strangers, he didn’t expect to be taken literally. Nonetheless, he made a good point.
In the final quarter of last year, the UK posted its highest ever current account deficit relative to GDP. So that’s trade in goods and services, net investment from abroad and transfers. And when I say forever, data goes back to 1772, the reign of George III.
Drill down, and it gets worse. In the UK, we are used to seeing a big deficit in trade, but until a few years ago at least net income flows were positive. But there was an oddity. The value of UK assets held abroad are worth less than assets held by foreigners in the UK. Yet net income flows to the UK were positive. Some looked at this data and said: “That can’t last. Sooner or later things will flip, net income will go negative, and when that happens the UK will be in trouble.”
Then, a couple of years ago, it did flip. I don’t know about you, but I don’t recall any economic earthquakes resulting. Alas, since then, things have deteriorated. By the final quarter of last year, net income from abroad also hit the highest deficit ever recorded. Some fretted that a sterling crisis was just one economic shock away.
Fortunately, investors continued buying UK assets and money continued to flow in, propping up the pound. These are the people Mark Carney says that we are reliant upon. But they were not being unduly kind, they were ploughing money into the UK because they saw it as a safe haven.
On the morning of June 24th, the UK did indeed suffer a shock. The UK electorate voted to leave the EU. Sterling tumbled.
This is an ongoing story. You have the advantage over me, by the time you read this you will know more about the direction the pound is heading in.
But step back and consider the last time sterling fell so dramatically.
In the summer of 2008, there were just over two dollars to the pound. By January 2009, the exchange had fallen to 1.38. Between June 2008 and the end of that year, sterling fell from 1.28 euros to the pound, similar to the pre-referendum exchange rate, to near parity.
At that time celebrated investor, Bill Gross, the so called bond king, said “The UK is a must avoid. Its gilts are resting on a bed of nitroglycerine.”
As these words are written, sterling is down to a 31-year low against the dollar, but the percentage fall was greater in 2008. Against the euro, the 2008 drop was also much worse. But then I am looking at a six-month period in 2008. This time around we have only a ten-day time horizon.
Much now depends on what happens next.
And what happens next partly boils down to trade deals. This matters for more than one reason. Firstly, there are UK exporters to the EU. Just as important, many companies invest in the UK as they see it as a bridgehead into the rest of the EU. If that bridgehead collapses, those companies may relocate, and the flow of new investment deals may flicker out. The EU also has agreements with other countries. If the UK leaves the EU, it will no longer be party to such agreements. Take as an example the Open Skies arrangement with the US, allowing the flow of air traffic between the EU and US. Contrast that with the Bermuda II agreement between the UK and US signed in 1977, which greatly restricted the flow of air traffic between the two countries. If the UK leaves the EU, will it need to come to a new arrangement with the US, and how long will that take?
So if the UK can somehow agree new trade deals quickly – or to use what may become the de facto language of the EU post Brexit: agree trade deals tout suite – then further falls in sterling may be alleviated. But if negotiations go slowly, then the pound may take another tumble.
You may ask, so what? History tells us that sharp falls in the pound are often followed by economic success. For example, after 1931 when the UK left the gold standard, or in 1992 when it was ejected from ERM. On the other hand, after the 1967 devaluation, inflation followed – despite the protestations of the then Prime Minster, Harold Wilson, the pound in our pockets and purses was affected.
The FTSE 100 may be relatively immune. It offers global exposure; a fall in the pound will act to boost foreign earnings of FTSE 100 companies measured in sterling. The FTSE 250, however, is more closely correlated with the UK economy.
Something has been forgotten by most commentators in recent days. We are told that in a worst case scenario, UK exporters may be subjected to tariffs under World Trade Organisation rules, and that the fall in the pound more than makes up for any tariff related hit. But little has been said about vitally important services. Agreeing trade deals with services is much harder than with goods. For example, Canada’s much lauded trade agreement with the EU does not apply to services.
It may all boil down to movement of labour. If the UK accepted free movement of labour from the EU, negotiations would run more smoothly.
Such a compromise would be unpopular with many.
That brings us to Article 50.
To leave the EU, the UK must formally enact Article 50, then it is on a two-year countdown. But such a move may weaken its negotiating position. The longer it delays Article 50, the more time it has to agree new trade arrangements before the cut-off point.
Meanwhile, other countries are making noises about holding their own referendums. If the UK walks away from negotiations smiling, or this current impasse continues for some time, the odds of other countries following suit rise.
So the EU does not want to cave into to UK demands. But neither does it want to see a long delay in the UK kicking off Article 50.
In any case, it is not in the EU’s interest to punish the UK too severely, no one wants to see a major fallout.
So while the UK is in a tricky position, so is the EU. Besides the EU has other major problems to contend with, such as a potential banking crisis in Italy.
For this reason, some think that, in an attempt to appease a growing number of EU cynics, the EU will make major reforms. Some are therefore saying that Brexit may never happen. Or maybe we will have a second referendum on leaving a reformed EU.
That leaves one more issue – the degree of division in the UK over the EU referendum. While many regions overwhelmingly voted to leave, Scotland, London and other major cities decisively voted to stay. Scotland is calling for another referendum on its independence, there was even a petition for an independent London that garnered 178,000 signatures.
One idea doing the rounds is for cities, such as London, to be granted different rules regarding immigration, such that they can issue special work visas that allow immigrants to work and live in these cities only.
Another school of thought says that an independent UK, unencumbered by the slow machinations of the EU, will be free to focus on agreeing trade deals beyond Europe, and be able to open itself to immigration from further afield. On this theme, positive noises have been coming out of India.
Meanwhile, there is a very real risk of a UK recession later this year – economic surveys, such as Purchasing Manager’s Indexes, were suggesting this was possible even before the referendum.
Further modest falls in sterling may give UK exporters another boost, but if the falls continue, perhaps because news on trade negotiations disappoint, inflation may begin to rear its ugly head, and the Bank of England may be forced to increase interest rates, even if such a move leads to slower growth.
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