KWASI KWARTENG, Britain’s new Chancellor of the Exchequer (pictured), insists he won’t be moved by currency exchange fluctuations. “Markets will react as they wish,” he told the House of Commons on September 23 after unveiling Britain’s biggest string of tax cuts in half a century, funded largely by borrowing.
His insouciance was put to the test. On September 26, the British pound collapsed against the dollar as markets in Asia opened up, falling briefly below $1.04. The decline comes after a hurting sell-off on Friday following Mr Kwarteng’s announcement. In the Asian sessions, the pound settled around $1.07, down about 1%, as interest rate expectations rose. The currency’s all-time low, as measured by the 4:00 p.m. London rate, was reached on February 26, 1985 at $1.042.
As in 1985, much of the fall in sterling this year reflects the strength of the dollar. Sterling is down around 20% against the greenback in 2022, not much more than the euro’s 15% and in line with the Japanese yen’s decline. But over the past week, the pound has fallen against most currencies, not just America. This fall has been accompanied by rising government bond yields, which would normally encourage international investors to buy sterling-denominated assets on the expectation of higher yields. UK five-year yields have risen from 1.5% in early August to over 4.5% now: a rise of about a percentage point in just two days.
This combination of rising yields and a falling currency has sparked discussions of a broader crisis of confidence in the UK economy and its assets. The government’s tax cuts will result in a growing budget deficit and higher national debt in the future. Britain’s current account deficit hit 8.3% of GDP in the first three months of the year, the lowest in modern history, buoyed by rising energy prices. A gaping current account deficit is something that often worries those investing in developing countries.
But in other respects the UK is an unusual candidate for a currency crisis. Its exchange rate is flexible, meaning there is no link to any other currency, as was the case when Britain was forced out of the European Exchange Rate Mechanism in 1992. Its financial markets are deep and sophisticated. It has minimal foreign currency debt and its central bank is independent of the government.
So the simplest explanation for the sell-off is that investors don’t believe the government’s tax cuts will result in the real economic growth that Mr. Kwarteng wants. Instead, they foresee higher inflation, which the Bank of England will not fully offset by raising interest rates. Currency analysts at Bank of America suspect that a combination of the UK’s shifting fiscal stance and the long-term implications of its decision to leave the European Union has prompted a major shift in investor sentiment towards the pound. This will make the currency more vulnerable in the coming years.■