The sudden fall in sterling could force a realignment of Britain’s economic relationship with the eurozone, resulting in potentially painful consequences for both it and the 15-country bloc.
Since November the pound has fallen by almost 9 per cent against the euro – a rate of decline not far off that seen during sterling’s enforced exit from the European exchange rate mechanism in 1992, when it fell 11 per cent against Germany’s D-Mark.
It is “astonishing how quickly [sterling] has gone down”, said Ben Broadbent, of Goldman Sachs. The drop is rekindling memories of “Black Wednesday” in 1992, which helped to bury the then Conservative government’s reputation for economic competence. Symbolically troubling, the currency’s weakness makes France’s economy larger than that of Britain for the first time since 1999.
The list of causes is long. UK interest rates are expected to be cut, Britain’s trade position looks increasingly precarious, capital inflows from companies buying UK assets have slowed sharply, and a perception of poor economic management has grown since the credit squeeze hit the world in August.
But most economists think the adjustment is necessary even if it hurts in the short run. The UK’s current account deficit is seen as increasingly unsustainable; it is now the largest among the Group of Seven leading economies after big downward revisions to foreign income at the end of last year.
Sterling’s hitherto sustained strength had fooled people into believing “you can run the economy permanently on the back of consumer spending and rising land prices”, said Martin Weale, director of the National Institute of Economic and Social Research.
Still, the pound’s fall will complicate the life of the Bank of England’s monetary policy committee by raising inflation, at least in the short term. Goldman Sachs estimates the direct impact will be an increase in inflation to more than 2.7 per cent by the autumn, or higher if the weaker currency has knock-on effects on wage claims and inflation expectations. In such a climate, the bank will be more cautious about cutting interest rates.
In the longer term, the erosion in real incomes implied by a depreciation might make the grass seem greener in the eurozone. While there is little economic merit in such thoughts, the strength of sterling and the perception that Britain was stronger than the eurozone have been powerful forces in swaying public opinion against joining Europe’s single currency.
Across the Channel, the focus could soon switch to the impact on eurozone exporters, who have accounted for much of the region’s growth in recent years. So far eurozone politicians have fretted about the dollar’s weakness. It is true that the pound does not have the same global role as the US currency, but the eurozone exports more to the UK than to the US.
Hence the pound’s fall will add to the difficulties already created by the slowdown in the US and the continuing global credit squeeze. “It is another source of potential weakness for the eurozone economy – and there is no shortage of them,” said Ken Wattret, of BNP Paribas.
The 4.5 per cent rise in the euro on a trade-weighted basis since last June – due in large part to sterling’s fall – would be expected to knock about 0.4 or 0.5 percentage points off growth if everything else remained equal, according to Goldman Sachs’ calculations.
So far the European Central Bank has not commented on the pound’s fall. It remains relatively upbeat about eurozone growth, which it expects to be in line with the long-term trend this year. Robust growth in emerging markets is expected to offset the impact on eurozone exporters of weaknesses elsewhere in the world.
Whereas Jean-Claude Trichet, ECB president, was happy last year to stress the US commitment to a strong dollar, he dodged a question last week on whether a strong pound would be in Britain’s interest.
That reflected the ECB’s reluctance ever to talk about exchange rates. At the same time, the actual effects of the pound’s weakness are hard to judge and will take time to work through.
The UK economy’s level of demand may prove more important than the exchange rate – but demand is weakening too.
Mr Wattret said: “It might be that the full impact of what we’re seeing in the UK, and the impact on the eurozone, has not yet registered at the ECB.”