October 3, 2009 3:00 am

Ragged pound may prove the best ballast for rebalancing

The pound is currently the currency that investors love to hate, and the Bank of England seems happy to keep it that way.

The pound has been the worst performing major currency over the past month, dropping over 4 per cent against the euro and even posting a 2 per cent fall against the dollar, the other pariah of the currency world.

Many believe sterling, which on Monday hit a low for the year of £0.9300 against the euro, is poised to break through parity against the euro for the first time, a nadir it just failed to breach at the turn of the year.

At the root of sterling's poor performance are concerns over the UK government's fiscal position and a belief that UK interest rates will be kept at ultra-low levels for longer than elsewhere.

Furthermore, the pound's performance has not been helped by a view in the market that the Bank is one of the principal cheerleaders of sterling's fall.

Ulrich Leuchtmann at Commerzbank says the Bank is "playing with fire", warning that it is easy for a central bank to talk down its currency, but another matter entirely to talk it up. Indeed, the pound took a sharp lurch lower last month after Mervyn King, the Bank's governor, said a weaker currency would be "helpful" in rebalancing the UK economy towards export-led growth.

The comments came just days after the pound was hit when Mr King told the UK parliament that the Bank was considering lowering the rates it pays on commercial deposits held at the central bank in an effort to stimulate lending: in effect, an expansion of the Bank's quantitative easing policy.

The pound recovered some ground this week after a meeting between several members of the Bank's monetary policy committee and leading City economists, at which it was reported that the Bank was unhappy with the way Mr King's comments had been interpreted regarding sterling's weakness.

But one economist at a leading investment bank present at the meeting in fact reported the opposite: that policymakers appeared far from unhappy about sterling's plight.

But the Bank's wariness in giving too much of an impression in public that it is in favour of a weak pound makes sense. It treads a fine line between encouraging the weakness it considers helpful in rebalancing the UK economy and encouraging a rout in sterling that could undermine overseas investors' confidence in UK assets.

This is especially true given one of the most significant worries for the UK is its fiscal situation: the UK government needs to act to restore enough credibility to government finances to prevent international debt buyers from going on strike and worsening an already difficult situation.

Indeed, the Bank seems to realise this. Last month, it said the currency's long-run value may have been fundamentally undermined by the financial crisis. It warned overseas investors might have reassessed their willingness or ability to purchase sterling assets and thereby finance the UK trade deficit, pushing the long-run sustainable real sterling exchange rate lower.

It is in this context that the Bank's comments on rebalancing the UK economy make sense as a reacceleration of the UK's current account deficit is occurring in an environment in which foreign financing has become much more difficult to acquire.

This was highlighted by this week's UK current account data, which showed the deficit was £2bn worse than expected in the first half of the year.

An improvement in the UK's trade balance was outweighed by deteriorating services and investment income balances. In other words, the UK's trade balance will have to improve significantly if it is to make up for the deterioration in other current account components in a world of scarce financing.

A weak currency is thus a necessary condition if the UK economy is to rebalance and recover. The Bank knows this and is right gently to manage sterling lower. Surely it is better to play with fire than to fiddle while Rome burns.


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