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Brexit, Europe, NEWSLETTER

Here’s why the British pound could depreciate further

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Stefano Francesco Fugazzi  reports.

According to a number of leading economists, the British pound is too strong, hurting both exports and current account balance.

In the aftermath of the Brexit vote, the British pound lost ground against the euro and the US dollar. Some economists believe that this is exactly what the UK needs in order to address its current account deficit.

“In our opinion, GBP is overvalued as GBP-supportive interest rate and yield differentials are inadequate to help to fund the UK’s 7% GDP current account deficit,” said Morgan Stanley in a client debrief.

The current account deficit has been a cause of concern for many economists who have been trying to project the value of the pound.

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The current account can be expressed as the difference between the value of exports of goods and services and the value of imports of goods and services. A deficit then means that the country is importing more goods and services than it is exporting—although the current account also includes net income (such as interest and dividends) and transfers from abroad (such as foreign aid), which are usually a small fraction of the total.

An importer would have demand for the currency of the exporting country. If we look at the UK’s trade balance we can see the UK is clearly a net importer, implying that Britain has a greater demand for foreign currency than does its counterpart which would mean the value of the currency must ultimately fall according to principles of supply and demand.

However, sterling is priced higher than this trade-based dynamic because foreign investors pour money into UK-based investment opportunities. Therefore, the exchange rate is higher than the level implied by trade dynamics.

MORE QE TO CAUSE FURTHER DEVALUATION. On 30 June, Bank of England governor Mark Carney said that it was likely “some monetary policy easing” would be required in response to the Brexit vote.

The promise of additional easing would most likely be delivered on at the next meeting of the Monetary Policy Committee on August 4th with most analysts predicting a 25 basis point cut to the interest rate and some suggesting an expansion of the quantitative easing programme will also be announced.

A rate cut would increase the money supply causing the currency to devaluate. As the sterling is currently overpriced, well above its ideal equilibrium level, this will be a good news, supporting exports and, hopefully, cutting the current account deficit.

 

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