The “pound in your pocket” may feel a little lighter than it did at the start of the year. In the past month, sterling has lost 3.5 per cent against the dollar and the euro. It has fallen more than 6 per cent against the currencies of Britain’s main trading partners since mid-November. Yet since Harold Wilson coined the phrase to explain his 1967 devaluation, such fluctuations in the UK exchange rate have stopped being a subject of national hand-wringing.
The recent sell-off is partly due to signals that UK policymakers are now unlikely to follow the lead of the US Federal Reserve in raising interest rates soon. The UK’s persistently large current account deficit also makes sterling vulnerable during market turbulence of the kind recently triggered by China’s slowdown. Moreover, the latest data confirm that Britain’s recovery has slowed as some of the eurozone’s weakest economies show signs of a pick-up, tempering the pound’s appeal relative to the euro.
Crucially, though, sterling has dropped in tandem with a sharp rise in the cost of insuring UK sovereign debt against default. Speculators are adding to bets that the currency will fall further. This suggests that investors are starting to act on fears that Britain could vote as early as this summer to leave the EU.
The moderate depreciation should if anything be of mild benefit to Britain’s economy. It will offer at least some relief to exporters struggling with a slump in global trade and will make it easier for policymakers to bring inflation back up towards target. It should not be too painful for consumers since the higher cost of imports only partly erodes gains from lower supermarket prices and the collapse in oil prices. Sterling remains in line with historical averages against most currencies apart from the dollar.
However, it appears likely that the exchange rate will become more volatile in the run-up to the Brexit referendum. In the event of a vote to leave the EU, it could take a bigger hit, especially if the resulting uncertainty were to lead foreign investors to pull out of the country and British citizens to move some of their money abroad.
Mark Carney, the Bank of England governor, this week underlined that Britain was “relying on the kindness of strangers” in running a current account deficit equivalent to 4 per cent or 4.5 per cent of national income, which it must finance either by borrowing or by attracting investment from abroad.
For many years, strangers have been happy to oblige and much of the foreign investment in Britain — in manufacturing or London real estate, for example — is of a long-term nature that would not evaporate overnight. But plenty of it is liquid too. Foreign investors hold about a quarter of UK government debt. The risks to financial stability, if a vote for Brexit triggers capital flight, are clear.
There is little the authorities can do to prevent this happening, although financial regulators can ensure the banking system is well capitalised and able to provide liquidity if wholesale funding markets come under pressure.
Sterling’s recent modest depreciation is in itself nothing to worry about. However, it reflects a real doubt over Britain’s ability to withstand a big shock to the global economy or the upheaval of Brexit would entail. The plunge in the pound that could take place in the aftermath of a referendum would be far more painful and difficult to deal with. The government should be concerned about the underlying imbalances in Britain’s economy that will make it vulnerable to capital flight should voters opt to split from the EU.