There is a silver lining to the beating sterling has taken in recent days
The pound fell 11% against the dollar in two trading days after the vote, and after another sudden slump last week is now down 16%. PHOTO: ASSOCIATED PRESS
By JON SINDREU and CHRISTOPHER WHITTALL
The Wall Street Journal
Updated Oct. 10, 2016 5:13 a.m. ET
When the U.K. voted to leave the European Union in June, the pound took its worst beating in half a century. Many economists saw that as a good thing.
Despite the shock of Brexit, more than three months later there are few tangible signs of economic distress in Britain: Employment is steady. The stock market has held up. Government bonds are strong. Houses are still being bought and sold. Consumers are still consuming.
Credit, say economists, goes in large part to the decline of the British pound, which has acted as a giant shock absorber against Brexit. It fell 11% against the dollar in two trading days after the vote, and after another sudden slump last week is now down 16%.
Seen from abroad, British people are one-sixth poorer and their economy is one-sixth smaller. In the past week, figures from the International Monetary Fund suggest, Britain has slid from the world’s fifth-largest economy to sixth, behind its millennium-old rival France.
But suffering Brexit’s pain through the currency may be more comfortable than through higher unemployment or other ills—a luxury that wasn’t available to eurozone countries during the currency bloc’s debt crisis. Over the longer term, economic wisdom holds that a weaker currency will boost a nation’s sales abroad, so what the economy loses in the form of lower consumption—because consumers are poorer—will be recovered through higher exports.
“It is important that you have a live release valve like this,” said Tim Haywood, an investment director at GAM Holding.
Brexit is a significant test of that valve’s strength and reliability. In the short term, too chaotic and deep a plunge in a currency can trigger financial panic.
On Friday, sterling plunged to its lowest level in 31 years against the dollar after briefly tumbling over 6% in Asian trade. It capped a rough week for the currency after U.K Prime Minister Theresa May set a date for Britain’s exit from the EU.
The largest recent hit to the pound happened the day after the Brexit vote on June 23, when it lost as much as 8%, the steepest single-day drop against the dollar since Nov. 18, 1967, according to FactSet.
Back in 1967, U.K. officials grappled to keep sterling pegged to the dollar amid a weakening economy and as foreign investors pulled out of the country. Finally, British Prime Minister Harold Wilson was forced to devalue the currency from $2.80 to $2.40, a 14% drop.
Britain was lucky not to be pegging the currency when Brexit happened, analysts say.
“If they had had a fixed exchange rate it would have blown up,” said Kenneth Rogoff, economics professor at Harvard University.
Flexible exchange rates allow economies to absorb shocks in two main ways: They let the currency bear the brunt of capital outflows, rather than stocks and bonds, while boosting the competitiveness of local businesses on the global stage.
A floating currency allows a nation to set interest rates, steering the price of financial assets. By contrast, under a pegged-currency regime, in times of turmoil, bonds and equities are left to crash. Banks are left scrambling for liquidity.
Take the FTSE 250 stock-market index, which lists medium-size companies doing a lot of business in the U.K. For dollar-based investors, it has plunged 13% since the Brexit vote, but for locals measuring it in pounds, it has risen almost 4%.
Furthermore, the U.K.’s largest companies, such as British American Tobacco PLC, GlaxoSmithKline PLC and AstraZeneca PLC, make most of their income abroad. Their shares have surged because with a weaker pound, their revenues look much beefier. The FTSE 100 index, which comprises mostly such multinationals, is up 11% since the vote—although that rise is less than the pound’s fall against the dollar.
By possessing its own currency, the U.K. is able to deploy monetary and fiscal stimulus at will. U.K. Treasury chief Philip Hammond recently signaled that the government would ramp up spending in infrastructure to offset the possible impact of Brexit on consumer and business confidence.
Britain also has the advantage of a strong local financial system, meaning both the government and private companies can easily borrow in pounds. In contrast, in many developing economies borrowing happens in foreign currencies. When the local currency depreciates, foreign-currency debts balloon and often become unsustainable, which happened in the Asian financial crisis of 1997.
In 1970, almost every country in the world had a pegged exchange rate. Despite a certain rebound since the mid-1990s, now about 47% do, according to IMF data. The world’s leading advanced economies have all embraced floating rates.
What is more, financial panics in emerging-market economies, including Russia, Brazil and South Africa, have been mellowed over the past few years by the exchange-rate flexibility governments have mustered.
The eurozone, whose countries share a currency, offers an example of the danger a fixed currency can pose. In 2011 and 2012, stock markets in Spain and Italy plummeted more than 40% and investors dumped those countries’ sovereign bonds.
Being part of the eurozone also meant Southern Europe couldn’t control monetary and fiscal policy. Public spending was cut, taxes went up and unemployment soared. Unlike Britain, the troubled eurozone countries, which incurred a lot of debt during the crisis years, now face the hardship of paying back that debt in a currency that they can’t print.
The alternative was growth through higher exports. But for poorer nations to make their products more competitive is hard when sharing a currency with richer nations like Germany and the Netherlands. In Greece, the hardest-hit country, a faction of the now-governing Syriza party pressed the virtues of a flexible currency during the apex of the nation’s crisis. Syriza, and Greece, ultimately stuck with the euro.
“It’s the lack of currency flexibility that has been one of the fundamental problems that Europe has,” said Derek Halpenny, economist at Bank of Tokyo-Mitsubishi UFJ Ltd. “The flexibility of exchange rates is the big positive that the U.K. has going forward.”
According to most economic textbooks, a cheaper currency makes local companies more internationally competitive, while curbing imports in favor of local production. Some see tentative signs this is already happening in the U.K., crediting the weaker pound for a small summer rebound in manufacturing.
Manufacturers like Nissan Motor Co., which owns the U.K.’s largest car factory, in Sunderland, England, may be the main beneficiaries of a weaker currency—assuming they can handle whatever new tariff barriers they face in the EU once the U.K. leaves.
For the tourism industry, a weaker pound makes U.K. hotels cheaper for foreigners. InterContinental Hotels Group PLC, which has long been optimistic about the effects of Brexit, said it got a boost in the first half of the year because a weaker sterling slashed its costs.
But debate remains over how much a weaker sterling can offset the longer-term effects of Brexit, since exports don’t move on currencies alone. Also, it is possible that economic malaise from Britain’s leaving the world’s largest free-trade bloc will set in later, when Brexit actually occurs. Many economists are skeptical the pound can ever offset the trade impact of withdrawing from the EU. Tariffs with the EU would hurt exporters, and the British government’s attempts to curb migration, economists say, will dent the U.K.’s long-term productive capabilities.
“The currency offers some cushion in the near term,” said Allan Monks, U.K. economist at J.P. Morgan Chase & Co. “But the weaker currency doesn’t necessarily give such a strong boost to manufacturers’ exports and output.”
Indeed, the pound fell sharply after the 2008 global financial crisis, but British exports didn’t bounce back meaningfully. In Japan, ultraloose monetary policy has driven the yen down 25% against the dollar in the past five years, but exports have remained much lower than before.
Because supply chains are global, manufacturers increasingly use components from abroad to make products, so higher import prices matter to exports, too. IMF and World Bank research found that for countries that integrated themselves in global supply chains between 1997 and 2012, the currency lost 22% of its impact on exports.
That means currencies have to fall further to help buffer the economy, said David Bloom, global head of foreign exchange research at HSBC Holdings PLC, who forecasts the pound will sink to $1.10 against the dollar and to parity with the euro by the end of next year.
The outlook for U.K. exporters, however, remains strongly dependent on whether its trading partners—chiefly the eurozone—start growing at a faster pace. So far, their performance has been disappointing.
“No matter how much the currency goes down, people still don’t want to buy things,” said Mr. Bloom.
“I don’t think there’s any amount of sterling depreciation that can shock-absorb for the loss of economic potential,” said George Magnus, senior economic adviser at the Swiss bank UBS Group AG.
Write to Jon Sindreu at email@example.com and Christopher Whittall at firstname.lastname@example.org
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