Will the pound be pummelled by long-term gloom?

10th February 2012

Commenting on Mindful Money economist blogger Peter Morgan's post, GS asks: "Does that (the ill state of the British economy) imply we have weakening currency to look forward to?  The BoE will have to be careful with the QE now."

Yet despite bad news for the economy and a further bout of QE, the pound reached a session high against the dollar, reported Reuters. The pound rose 0.3% to $1.5871 against the dollar, and was 0.2% higher against the euro at £0.8366.

Why? According to analysts, markets had already priced in the fresh £50bn of liquidity, with the rise in sterling suggesting fears that the BoE could have announced a higher level of £75bn were allayed.

This batch of QE should support the pound for what may still be a very challenging year ahead. The eurozone debt crisis is a double-edged sword for sterling, as it keeps the euro weak but also dampens European demand for British exports – and therefore endangers the UK economic recovery.

Commenting on the news of sterling's reaction to the most recent bout of QE: "It is a bit of relief," said Richard Wiltshire, chief fx trader at ETX Capital on Reuters. "Sterling has been in a period of ongoing resilience and with the suggestion that inflation will achieve the goal of below 2%  without further stimulus, things are again looking positive for it."

But what of the long-term impact?

Peter Morgan, Mindful Money's economist blogger, says: "If QE continues the value of the pound will fall. This will have a consequence on the cost of imports and could potentially reduce the standard of living in the UK.

"In short, if the current trend continues and the financial crisis worsens the value of the pound is likely to drop in the long-term. Although there may be short-term spikes in the value if foreign investors see the UK as a safe-haven for economies in a worse situation, its long-term value will decline."

Simon Ward, head of economics at Henderson, adds: "Outbreaks of gloom tend to be negative for sterling because market participants regard the BoE as super-dovish and more liable to ease policy in response to economic weakness than other central banks.

"Gloom also implies financial market weakness, and the UK economy is still perceived as being more closely tied to finance than other economies."

Why has sterling suffered so far?

Since the financial crisis erupted in 2008, sterling has lost value. Some of the reasons for this include record low interest rates, the BoE's QE programme, the UK's poor fiscal position, with a large growing public sector deficit – and perhaps suspicions that policy-makers want a weak pound in order to boost exports, and don't mind inflation staying above target because it will reduce the value of the massive public debt.

However, certainly during 2011 sterling proved relatively stable, says Investors Chronicle. The eurozone's debt crisis hasn't been a reason for sterling to rise. The UK economy would also suffer if the crisis deepens – and fears about the crisis have thus been a reason to avoid both sterling and euros.

Yet there is no denying the impact of a strong economy on sterling. Successful economies can enjoy artificially strong purchasing power against other countries.

Peter Morgan explains on his blog: "However for this to happen, the country has to start with a certain level of stability to provide that security.

"…The desire to hold British financial products creates demand for the British pound that gives the currency an artificially high purchasing power on an international stage. Therefore regardless of the commissions and bonuses the city earns and the amount the government receives in tax, the real benefit of the financial sector is the artificial purchasing power it creates for the British pound. The income generated in the city is only a small percentage of the total investments made. It is this investment demand that creates currency demand which creates the real benefit of the British financial sector to the rest of the economy.

"If the financial sector in the UK declined not only would the income earned by banks and the government diminish, but the ability of the UK to purchase foreign goods would also fall."

 

More from Mindful Money:

Alternatives to quantative easing

Should investors be worried by corporate defaults?

Are positive manufacturing results a sign of a rebalancing UK economy?

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