Reasons for the Sterling collapse in early October 2016…
I don’t see where the support for Sterling should come from. There’s only the relative argument, as in, is the UK in a worse state than Europe? Europe is it’s main trading partner, and additionally the UK acts as the gatekeeper to the Continent’s finance sector, capturing most of the banking and transaction business as a result of it’s ‘passporting’ privilege. The UK has to find a sustainable divorce method that keeps this access alive.
What’s changed this last week is the harder talk about how and when Brexit would happen, and it was perhaps timed into a period of apathy on the investor side, where a sense of denial of the referendum outcome and the strong nationalist and protectionist forces may have set in. The new PM has set a date by which Article 50 will be invoked (April 2017) and made it clear that curbing immigration, i.e. curtailing free movement, will be a cornerstone of her ‘strategy’, which puts her at odds with EU leaders who have spoken clearly that this is not reconcilable with free access to the EU common market.
Trade Deal Renegotiations
What this means in practice is still unclear, and as such a negative. The UK is currently physically able to negotiate about four bilateral trade agreements per year with other countries, such is its staffing in the relevant departments. So some sort of a ‘grandfathering’ solution will have to be found whereby existing agreements either stay in place or revert to some agreeable standard until the relevant treaty can be negotiated in full. WTO standards are the ones generally mentioned, which seem to be based on reciprocity. I cannot imagine that from the moment the UK officially ‘leaves’ the EU, in 2019, this means that it cannot export goods into the common market. Someone has to actually impose tariffs where there were none for this to happen. At this point the UK would then retaliate, and so the process would escalate and envelop trading standards in all sorts of industries, escalating out of control and most definitely hurting the exchange of goods, which is something no one wants, unless we are talking about a reaction to a ‘dumping’ policy or behaviour, something that hasn’t really happened, yet. In any case, before a process spirals out of control, it’s in everyone’s interest to keep the status quo. Only in our ‘dumping’ scenario, where the exchange of goods poses an imminent threat to an industry and ultimately jobs in one country (or multiple ones), would a rapid imposition of tariffs make sense. Again, there seem to be no such issues now, though that’s not to say that future political issues like closure of British steel furnaces could take their place. Another one would be if UK-based firms were denied passporting rights with regard to banking and financial services. The tremendous importance of this sector to the UK economy might just result in retaliatory action, though it’s not clear to me how – are we going to shoot ourselves in the foot by making German cars more expensive for now unemployed bankers and lawyers? Yet another scenario is where one party, either Europe or the UK, becomes a conduit for dumping of products from an extraneous partner, for example, our new special relationship with China makes it easier for that country to flood Europe with goods that are initially exported to the UK, thus avoiding European measures to prevent a direct inundation. It’s going to be a dynamic relationship, and in the absence of extreme behaviour now, trade-inhibiting measures are a bridge to be crossed when we get to it. Nothing happens until someone makes an effort to change the current status quo, and on this point the ball is in the EU’s court, that’s a body of then 27 member states that will have to agree such action.
What’s imminently more worrying is the anti-foreign rhetoric that accompanied our new PM’s speech via Home Secretary Amber Rudd, who called for British businesses to effectively be ‘named and shamed’ for employing non-British citizens, or worse even, forcing companies to identify these employees (I think she actually said they’d have to provide a list or number, but this smacks of labelling people and branding them in a way that the Continent has had very bad experiences with in the middle of the last century). She is going against everything London stands for, and her immaturity on this point is extremely worrisome, it appears that Mrs. May is having to oversee not only her Foreign Secretary Boris Johnson, Brexit Minister David Davis, and Trade Secretary Liam Fox, none of whom seems to have a ‘plan’, direction or discipline, but now also her successor. This ‘one-woman’ bet is far from having a coordinated, inspiring dream team in place. Yes, seventeen million people have spoken in the referendum, and yes, Mrs. May is the first politician I know who claims to have listened to them. I’m just not sure she’s understood, and once she starts touring the country and gets an understanding of what the underlying issues are that have driven half of Britain to reject the previous Conservative government she was part of, I hope she can move away from pointing at foreigners as the root cause of dissatisfaction, and abandon the progrom-mentality for something more constructive, and importantly, economically inclusive, that is geared towards growth and not punishment of those who do well.
Where we are
So there we are, we have certainty now that the current government is willing to act on the referendum and start the divorce, and we know they are willing to go an aggressive course, for now. What this leaves us with is a couple of years of uncertainty until the divorce is consummated and the terms are clear. The above described rational way forward of not escalating into a tariff and trade war is the most desirable route but not a guaranteed one. It does not mean that sense will prevail and multi-billion pound investments into the UK are thus advisable. It does not mean that the UK is a proxy for or gateway to Europe. And this won’t change materially until negotiations start in earnest, and even then there’s years of debate and uncertainty, exit is envisaged for 2019 and the next elections are in 2020 so an element of populism will be back-loaded into the final years of the divorce process.
The Trade Deficit
Meanwhile, the UK has a balance of payments issue. Since the 1980s, it’s been in a process of de-industrialisation, and manufactures less goods so has to import more; the economy has become more services oriented, yet the value of the services exported is less than the value of goods imported, so it’s running a current account deficit. This can be made up by direct investment into the UK economy from abroad, and so far this has helped, with UK assets providing an attractive yield, and the capital inflow dampening the growing current account deficit in recent years.
Why Invest in the UK Now?
With the new uncertainty, investment in factories and businesses is at risk. There remains property, in particular London, and foreign ownership is under scrutiny, for a number of reasons, including funding transparency (money laundering concerns) and the displacement of the local population due to pricing and vacancies (buy-to-leave), though the brakes have not really been applied yet among all the talk. Some of this is in the hands of local government, such as the Mayors of London, and less so, Manchester. The attractiveness of this sector is upheld by the strong legal framework, ownership rights, perceived safety and London’s status as only real ‘world city’ in Europe with a truly international and English-speaking community that caters to all expatriates with regard to culture and lifestyle, plus an excellent infrastructure with global and regional airline hubs. In addition, labour law is superior to versions of it on the continent, and social costs to employers are lower. Paris needs serious reforms in this regards to become palatable in scale, Frankfurt suffers from parochialism, Brussels isn’t deemed safe nor sizeable, and Dublin has even worse weather. There are opportunities for these towns, plus Madrid, Lisbon and Vienna, to attract talent (did I mention Luxembourg?), and the weekend commute to family in London is feasible, yet London is difficult to emulate in a sensible timeframe.
The Current Account Deficit and the Exchange Rate
Returning to the current account deficit, this is a structural problem the UK needs to tackle now that the mitigation from direct investments is under threat, or at least on hold during this time of political limbo. One cause is a low saving rate, currently around 4% of disposable income, and one of the lower rates in the developed world, with a declining trend. This implies high consumer spending, and goods are increasingly imported as a result of the transition from manufacturer to service provider, so this results in a trade deficit due to more imports than exports. It also implies that the economy could be excessively skewed towards consumer spending rather than investing and exporting. If UK goods’ competitiveness falls, this exacerbates the trade imbalance as goods are more difficult to export. The same is true if the exchange rate is deemed to high, and crucially, this where a correction can start to set in.
One way to affect the exchange rate is by reducing official borrowing costs; the currency becomes less attractiveness compared to higher yielding currencies, such as the Dollar. The Bank of England has reduced rates and is willing to go further it seems; there’s a credibility gap at some point, as Japan has experienced, where rock bottom means there’s a perception that they cannot actually lower them any more, and so suddenly the currency actually becomes a relative safe haven, as investors believe it’s the least likely to experience further drops in returns. Hovering near zero means that point is quite close; in addition, the monetary easing experiment is proving to be less effective than thought and starting to go out of fashion, though that doesn’t spell an end to low rates.
Investors in Control
The other way is investor driven; they sell the currency before the central bank can lower rates, that is, in anticipation. Investors set a level where they believe the economy can become competitive again, and to reach a stable level, this requires some conviction, which there doesn’t seem to be at this point, with this visibility of the UK’s role and access to markets. The possibility of further drops makes investment now less attractive, potentially causing further loss of direct investment and a negative spiral effect.
Where is the Vision?
What is needed is a vision, a plan, a roadmap, and concurrence among central bank, government and voters as to how to achieve this. The second best would be a relative deterioration in the economies of key trading partners, i.e. the EU and the US.