- The UK’s current account deficit is the main reason why the pound has fallen by more than other currencies against the US dollar over the past fortnight. The same was true in the Global Financial Crisis, and the pound never really recovered. But the pound was not overvalued going into this crisis, so there is more scope for it to bounce back this time.
- While all currencies have fallen against the US dollar over the past fortnight as investors have clamoured for dollars, the pound has fared particularly badly, touching a 35-year low of $1.14 at one point. (See Chart 1 and here.) At the time of writing the pound is down by 11% against the US dollar, 7% against the euro, and by 9% on a trade-weighted basis since the start of the year.
- There are three plausible reasons why the pound has been particularly hard hit. First, investors had speculated that a large fiscal stimulus and a resolution to the Brexit process would boost the pound. But such support has fallen away since investors have refocused on the hit to the economy from the coronavirus. Second, the UK’s relatively late lockdown and the fact the economy is predominantly services based may have led investors to think that the UK economy will be particularly hard hit. Indeed, the number of COVID-19 deaths in the UK has risen faster than it did in China or Italy in the early stage of the outbreak.
- But the key underlying factor was surely the UK’s large current account deficit which, as we pointed out last year, left the pound vulnerable to a sudden turn in investor sentiment. Indeed, the currencies that have fared particularly poorly in recent weeks are generally those of countries which have the worst external positions. (See Chart 2.) This is crucial as the UK relied on inflows of investment equivalent to about 4% of GDP in 2019 to finance its current account deficit. This reliance on external finance meant that the sudden deterioration in risk appetite and scramble for US dollars caused a sharp fall in the pound.
- This is nothing new. The UK also had a large current account deficit preceding the the IMF crisis, Black Wednesday, the Global Financial Crisis and the EU referendum. And there is a similarity with the Global Financial Crisis in that the pound has lost ground in tandem with a fall in equity prices. After 2008 the pound recovered once investor sentiment turned, rising 14% on a trade-weighted basis in early 2009. But it never returned to its previous levels. (See Chart 3.)
- But there are good reasons to think that, unlike after 2008, the pound will reverse more of its fall this time. Decisive central bank and government intervention has already started to reassure investors, reducing the clamour for US dollars. In time, the virus will pass and more conventional drivers of currencies, like interest rate differentials, will be back in the driving seat. (See here.) We now think the Bank of England will keep its policy rate at 0.10% for the foreseeable future, down from 0.75%. But the Fed has slashed the US policy rate by much more, from 2.25-2.50% a year ago to 0.00%-0.25%, where we think it will stay. This should mean most currencies, including the pound, regain the ground they have lost to the dollar after the pandemic peaks. (See Chart 4.)
- What’s more, unlike in previous crises the pound was not overvalued beforehand. Admittedly, the pound’s fair value has been on a downward trend in the long term. Occasional large falls in sterling, which decrease the value of the UK’s foreign liabilities (denominated in sterling) and boost the value of its assets (some of which are denominated in foreign currency), is how the UK affords to run a near-permanent current account deficit. But whereas the pound was above its long-run trend and fair value on a purchasing power parity basis (of roughly $1.40 according to the IMF) heading into the Global Financial Crisis, it already looked undervalued on both counts this time around. (See Chart 5 & 6.) Some of this is due to the “Brexit discount” that has weighed on the pound since 2016. But unless the UK leaves the transition period without a trade deal this will eventually unwind, or at least diminish if the transition period is extended.
- Overall, the fall in sterling in recent weeks has uncomfortable echoes of 2008, after which it never recovered. But the fact that the pound looks somewhat undervalued give us reason to think that sterling will make up the lost ground this time around. We expect the pound to recover from $1.17 to about $1.25 and from €1.09 to about €1.14 by the end of the year.
Chart 1: Exchange Rates
Chart 2: Current Account Balances & Currencies
Chart 3: FTSE 100 & Trade-Weighted Sterling
Chart 4: Interest Rate Expectations & $/£
Chart 5: Sterling Trade-Weighted Index (2005 = 100)
Chart 6: Purchasing Power Parity & $/£
Sources: Refinitiv, Bloomberg, Capital Economics, IMF
Andrew Wishart, UK Economist, +44 7427 682 411, email@example.com