Lower Pound No Cure-All for U.K. Economy
The hope that a depreciated pound will pull Britain out of recession—and that the economy will re-balance away from its dependence on consumer spending toward more export-oriented growth—risks being wishful thinking. While there are tentative signs that the weaker pound is underpinning exports, improvements have been far smaller and far slower than expected at the onset of the financial crisis. And there are reasons to doubt that devaluation will work the wonders hoped for by the U.K. government and the Bank of England. Again and again, the BoE has reiterated how a weak pound will benefit Britain's economy, comments which have overall placed some downside pressure on the value of sterling vs. other currencies. Indeed, minutes from the November meeting of the BoE's Monetary Policy Committee noted past sterling depreciation as one of the main reasons to expect an economic recovery. While little hard evidence of an export revival is currently available, there have been some tentative signs of improvement to U.K. trade balances over the past few months. Meanwhile, the weaker pound has helped to underpin Britain's consumer prices, as import inflation has partly counteracted significant downside forces to price growth, such as the cut in the Value Added Tax (VAT) and rising spare capacity in the economy. However, since late December 2008, the pound has appreciated almost 12% in trade-weighted terms, making U.K. exports somewhat less appealing price-wise. The currency still stands 23% lower, compared with its peak in January 2007, though sterling is largely at par with its level a year ago. The Last to Bounce BackThe pound's appreciation this spring was mainly attributed to the anticipation of Britain's economy coming out of the recession faster than previously anticipated. These expectations were ultimately crushed, with the U.K. now appearing to be one of the last of the major economies to escape the recession, after gross domestic product unexpectedly contracted by 0.4% in the third quarter based on preliminary data. Meanwhile, the outlook for the government's record deficit remains unclear. With a general election to be held by June next year, and the Conservatives leading the polls, market players lack details on how the next Parliament will tighten the budget deficit. However, it is widely expected the Conservatives would cut government spending and tighten the budget gap more quickly and more sharply than the current Labour government set out in its April budget. Nevertheless, rating agencies' recent threat of a U.K. sovereign bond downgrade, should the public finances not be brought under control, continues to loom. And the temptation for the government to inflate away the debt problem remains. The Greenback FactorDespite this, the trade-weighted pound has not suffered seriously. One reason: General weakness in the U.S. dollar, attributed to increased risk appetites and stronger stock markets, which have caused investors to move out of the greenback. Meanwhile, corporate fund flows have been a supportive influence to sterling, along with ongoing demand from sovereign wealth funds that continue to move in to relatively cheap British assets. Should the pound remain relatively strong or strengthen further, it will place a drag on export industries, damping the pace of economic recovery. Overall, British manufacturers appear well-placed for the global economic recovery once it occurs, after having restructured operations and downsized workforces during the recession. Indeed, it will be important that sterling remain relatively weak, since further strength would not only hamper export growth but would underpin import demand as domestic demand recovers. There is still the risk, however, that despite further sterling weakening, depreciation will be slow in boosting exports, meaning that Britain's economy for some years might have to suffer under the burden of a weak pound without the advantage of strong net benefit to trade. That ultimately increases uncertainty about the strength of a U.K. economic recovery.
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