Last updated: February 22, 2013 11:35 pm

Pride came before the fall for the pound

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Investors will not lose by selling something for more than it is worth
Sterling's zig-zag path

Britain’s pound sterling is a source of national pride. During the country’s long debate over joining the euro, many politicians seemed as proud of the pound as they were of Shakespeare, The Beatles, or the Battle of Britain.

It is hard to see why. More often over the last few decades, the pound has caused deep national embarrassment.

Sterling is back in the news, because the UK is winning the latest battle in the “currency wars”.

Briefly, in the early days of January, the pound was worth $1.62. That was near the top of a stable range in which it has been trading for more than three years. Since then, it has had a juddering slide, falling more than 7 per cent on a trade-weighted basis. Against the dollar, it dropped to below $1.53, even before the downgrade. This was sudden but in no way surprising.

In part, the UK could blame forces beyond its control. Last year, investors were preoccupied by political risks in the US and the eurozone. That made the pound a “haven” currency, despite the woes of the UK economy. As the new year dawned, with the US having survived its “fiscal cliff” talks, and the eurozone remaining intact, many investors no longer felt the need for such a haven. That alone was reason to fear that the pound would fall.

Past history was also a guide. The pound has a habit of trading sideways for long periods, and then diving or surging in a hurry. During the financial crisis years 2007 and 2008, it dropped 32.6 per cent on a trade-weighted basis. Against the dollar it fell 36.2 per cent to $1.35.

The subsequent performance of the UK economy shows why economic policy makers might want to turn into currency warriors. Initially, the UK weathered the “Great Recession” of 2009 rather better than most advanced economies, but it had far more of a problem with inflation. This was down to sterling’s stealthy devaluation ahead of the crisis. According to David Bloom of HSBC, the UK’s healthy exports in the two years following the devaluation, achieved despite near-disastrous conditions in many of its trading partners, added between 2 and 3 per cent to gross domestic product. But higher import prices meant that inflation, comfortably below that of the US for much of the decade before the crisis, suddenly shot upwards, twice topping 5 per cent.

So, you can “win” a currency war (meaning you boost your exports) if you can put up with higher inflation. January brought the news that the UK’s policy makers had a motive to do just that once again, as the economy had economy had contracted in the fourth quarter of 2012, opening the possibility of a “triple-dip” recession.

It also brought the beginning of a transition at the head of the Bank of England, with an incoming governor, Mark Carney, who appears more tolerant of inflation than his predecessor. This week brought the publication of the BoE Monetary Policy Committee’s latest minutes, showing that three of its nine members, including the outgoing governor Sir Mervyn King, voted for a new round of quantitative easing – buying gilts to push down yields.

In combination with the news that several of their opposite numbers at the Federal Reserve (but not chairman Ben Bernanke or his deputy) were voicing doubts about the Fed’s own programme of bond purchases, this pushed the pound through a trap door.

Is the fall over? Not necessarily. Hedge funds have been piling on so far this year, but the futures market suggests that traders have not yet bet on further falls. Purchasing power parity – tracking inflation in different countries to gauge an exchange rate that would buy the same basket of goods in each country – suggests that the pound should be at $1.458, says the Organisation for Economic Co-operation and Development. It is still overvalued. The market has yet to react to the downgrade, which while gossiped about, is certainly not in the price.

Sterling needs to fall 7 per cent to reach its low from the crisis period. It is quite possible that it will get there. And history shows that the pound can stay deeply under- or overvalued for a long time depending on political will.

What lessons can be learnt? First, if a country can put up with inflation (which tends to mean developed economies rather than emerging markets), it can force its currency down, and gain from doing so. That privilege is what maintaining the pound amounts to.

Second, if you get the chance to sell something for more than it is worth – as was the case when the pound was trading at more than $1.60 earlier this year, and certainly back in 2008 when it was trading at more than $2.00 – you should take that chance. Timing the foreign exchange market is difficult, and moves when they happen can be brutally swift. But in the long term, fundamentals come into play, and you will not lose by selling something for more than it is worth. Britons might still want to overcome their pride and sell more pounds.

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