Tag: Exchange Rate

Why has the British Pound (GBP) depreciated since the BREXIT vote?

Selin Ozyurt

I made this video in 2017, a year after the Brexit vote. In 2020, the Brexit chaos still continues and the exchange rate of GBP did not recover to its pre-referendum value. The reasons below are still relevant to explain the current weakness of the GBP.

In this video, I answer the following questions:

1. What is an exchange rate?

Exchange rate is the value (or price) of a currency compared to another one.

2. What determines the exchange rate?

The market: Supply and demand. When there is a strong demand for a given currency, this currency appreciates, vice-versa.

3. What happened to the exchange rate British Pound (GBP)?

The British Pound (GBP) has strongly depreciated right after the Brexit vote, up to 20% against the euro for instance. The exchange rate of the pound did not recover to its initial value since then.

4. Why has the British Pound depreciated?

3 mains reasons explain the deprecation of the GBP:

Reason 1: The UK economy is expected to be POORER and LESS PRODUCTIVE in the coming years, compared to the situation where it stayed in the EU.

  • The UK has significantly benefited from the access to the EU Single Market. Being a part of the European supply chain enabled UK producers to produce in a more efficient way by cutting production costs.
  • The reestablishment of border controls and custom duties would make the UK LESS attractive for foreign investors and diminishes demand for GBP.

Reason 2: Monetary policy: Low Bank of England policy interest rates

  • Investors tend to buy assets of countries that offer high interest rates (and high returns). Therefore, high policy interest rates increase the demand for the currency of this country.

Reason 3: UNCERTAINTY around the future UK-EU relationship

  • Markets DO NOT LIKE uncertainty! Investors prefer to invest in other countries than the UK and this lowers again the demand for GBP.

I hope you find the video helpful. Please leave me a comment to give me feedback or further questions.

If things works well, I would like to come back with new videos on “low interest rates and the policy challenges” they imply.

SEE YOU SOON?

What is next? Will the pound depreciation continue in 2017-2018?

Selin Ozyurt

#Brexit Facts

Part 2

Exchange rate developments are hard to predict as they react to various internal/external developments at the same time. This being said, I will discuss 3 key issues, which suggest that the pound will not recover to its value before the Brexit vote and may depreciate even further against major currencies in the years to come.

1. Persistent uncertainty regarding the EU-UK relationship in the future: The triggering of the Article 50 implies that the UK will leave the EU in March 2019. After being delayed due to general elections, UK started Brexit negotiations started in June 2017 without a mandated government and a clearly communicated strategy. Moreover, given the legal and practical complexity of reaching a satisfactory arrangement, it is very likely that the Brexit talks continue for some time. Markets do not like uncertainly, moreover the pound is not an international reserve currency in the same way as the dollar is. As a result, business and consumer confidence, which are already at low levels, may deteriorate further throughout the year. Therefore, I expect investors to continue to shy away from the pound, which will hinder the recovery of the exchange rate.

2. Prospects of low growth and productivity: The governor of the Bank of England stated in June 2017 that weaker real income growth was likely to accompany the transition to new trade arrangements with the EU. The UK is expected to be poorer after Brexit with lower incomes bringing weaker demand and an economy functioning under its potential. The Bank of England and many major institutions have recently lowered their UK growth forecasts up to 2019. Obviously, weaker growth expectations will continue to hold the value of the pound down in the future.

3. Monetary tightening in the US and euro area: Investors seeking high returns purchase assets of countries that offer high interest rates. That is to say, high interest rates render a country’s assets attractive to foreign investors and increase the demand for for the country’s currency. Obviously, this higher demand triggers the appreciation of the currency. 

After almost a decade of accommodative monetary policy, growth and unemployment in the US and euro area are finally recovering. The Fed has already started to gradually raise interest rates and the European Central Bank is also preparing to do so. Turning to the UK, the picture is rather different:  Economic growth decelerated significantly in the first quarter of 2017. On the other hand, the UK inflation reached 2.9% in May 2017, a rate well above the 2% policy target. Therefore, the Bank of England is facing a tremendous policy challenge. Raising interest rates ‘too soon’ in an environment of continued economic uncertainty and weak demand is likely to hinder economic activity. On the other hand, lack of reaction to inflationary pressures may also pave the way to ‘stagflation’, a concertedly dreaded illness by economists and policy-makers. All in all, the decoupling of the UK interest rates from the rates of the other major economies would result in a relatively weak pound exchange rate vis-à-vis the dollar and euro.

Based on these three aspects, my take is that, pound is unlikely to recover to its value before the Brexit vote and could depreciate further in 2017-2018. In an import-relying economy like the UK, a weak currency drives inflation up by making imports of energy, food, raw materials and intermediate goods more expensive. The UK producers declare that they have not yet fully passed the increasing input costs on retail sale prices. This implies more inflation and lower real incomes in the future.

Next Thursday, I plan to discuss the appropriate policy responses to the UK’s economic challenges. A largely missing topic from the current political debate…

I hope you found this article helpful. Please leave me a comment for feedback and questions.

 

Evils Never Come Alone: Brexit & Sharp Depreciation of the Pound – What is Next?

Selin Ozyurt

#Brexit Facts

One of the immediate consequences of the Brexit vote in June 2016 was the sharp depreciation of the pound against virtually all major currencies. The pound has not recovered since then and showed strong volatility during major political events (e.g. May’s October 2016 Speech, the announcement of the snap general election). It is striking that the UK government did not communicate much about the causes and consequences of the depreciation. In the general election campaign the depreciation  was treated as an external ‘calamity’ and his painful consequences for the Brits were mostly excluded from the political debate.

Main economic impacts of  the currency depreciation on the UK economy are:

  • High inflation, mostly driven by high energy and food prices
  • Erosion of the purchasing power and wealth of households
  • Declining real wages (for the first time since mid-2014)
  • Weaker demand: slowdown of consumption and investment

As opposed to Brexiteers’ expectations, a cheaper currency did not support growth by boosting  exports. The economy lost momentum and the UK became the slowest growing G7 country in the first quarter of 2017.

Part 1: Why did the pound fall sharply after the Brexit vote?

Let’s have a closer look at the reasons behind the dramatic fall of the pound. You will see that, the ‘why’ of the depreciation is tightly related to the policies followed by the government. I will only mention 3 guiding principles of international finance, which will explain the situation:

  • Financial markets seek to price ‘today’ what they expect to happen in the ‘future’.
  • Capital tends to flow to countries that can make productive use of it or where assets are safe.
  • Investors do not like uncertainty!

The pound fell immediately following the Brexit vote as markets believed that UK economy would grow slower and be less productive after leaving the Single Market. The core belief was that the value of the pound would remain persistently low after Brexit. Thus, massive pound sell-offs followed the  vote. The perverse effect of the sell-offs was  immediate pound  depreciation although the UK economy was doing ‘fairly’ good at that time.

This brings me to the next question: Why would the UK economic growth and productivity slowdown after leaving the EU? UK economy has significantly benefited from access to the Single Market via increased specialisation (especially in financial services) and better efficiency. In this sense, leaving such a large common market is equivalent to a ‘deglobalisation’ shock and scaling down production. To illustrate, financial services being scattered across major European cities would mean less specialisation, less efficiency and lower productivity for the city of London.

Moreover, restrictions to labour migration will eventually weigh on  growth and productivity. Skill shortage is already a serious issue in some  sectors such as information technology, healthcare and engineering. More importantly, the UK immigrant workers happen to be more educated on average than the natives. All in all, labour migration restrictions  are estimated to reduce the UK GDP by 0.6% to 1.2% until 2020  (Portes and Forte 2017).

Here is the warning by the HM Treasury before the Brexit vote:

“If voters choose to leave the EU, Britain would be “permanently poorer”! Productivity and GDP per person would be lower in all alternative scenarios, as the costs would substantially outweigh any potential benefit of leaving the Single Market. Separating from the EU would reduce GDP by 6% to 7.5% permanently.”

Last but not least, financial investors do not like “uncertainty”. The uncertainty around the future UK-EU relationship was one of the major forces driving the pound down over the last year. In particular, the incoherent approach of the government to the negotiations created serious doubts about their capability to negotiate an ‘acceptable’ deal for the UK. In an uncertain economic environment, firms adopt a ‘wait and see’ approach and delay investment decisions. Again, weaker investment becomes a drag on economic growth and productivity.