What does the crash of the UK Pound mean?

On October 07th 2016, the UK Pound suddenly crashed by over 6% in a matter of minutes, although it did manage to recover some of its losses. The reason for the sharp correction in the UK£ was apparently a robot-trade which was an outcome of an algorithm gone awry. However, the truth could be much deeper. It is possible that the sharp correction in the UK£ may be indicative of a larger malaise with the global value of the Pound. Secondly, it is also possible that heavy short positions were built in the pound in the post-Brexit scenario which could have resulted in this crash. Last, but not the least, it is entirely conceivable that the reduced volumes and depth in the global currency markets could have triggered a bottomless fall for the currency. One thing seems to be clear that the UK£ is under considerable pressure as is evident from the price graph of the Pound.

At an exchange rate of $1.24/£ the UK Pound is at a multi-year low. Back in 2007, the Pound had touched a high of $2.15/£ before crashing to as low as $1.37/£ at the height of the sub-prime crisis in 2009. In the post-Brexit scenario, the Pound has crashed sharply from $1.48/£ to a low of $1.24/£. So, what does a weak pound mean for the global economy?

Who benefits from a weak Pound?

Basic economics dictates that a weak currency has been used as a critical strategy to push exports when economies are looking to export their way out of trouble. That is exactly how Japan managed to export itself out of the ravages of the Second World War. Back in 1992 when the Pound crashed and was ejected from the ECU, British exports benefited substantially from a weak currency. The current situation may, however, be slightly different. Firstly, British goods tend to be high value-added products and hence their demand tends to be fairly inelastic. That means shifts in exchange rate economics do not materially impact their export volumes. Secondly, the biggest trading partner for the UK continues to be continental Europe. This is a major area of concern. The EU region is going through a major economic slowdown and despite their lose money policy there has been no economic respite. Also, in the post-Brexit scenario, UK is likely to lose out on its favoured nation status with the EU and that is likely to negatively impact its exports to this region. A weak pound may not substantially benefit UK.

Post Brexit, UK loses out on capital flows…

The UK has been largely depending on foreign capital to bridge its fairly vast and disconcerting current account deficit. The increase in UK’s current account deficit (CAD) has been quite disconcerting over the last few years. Between 2011 and 2016 the CAD of UK has deteriorated from -0.85% to -7.20%. A high current account deficit is tantamount to borrowing for your morning breakfast as your borrowings are being channelled into unproductive consumption expenditure. At current levels of CAD, the British Pound is bound to depreciate aggressively. The impact on the pound may become more evident when the growth and exports will fail to take off as a combined impact of Brexit and a weak Europe. But two other things could really be a worry for Britain. Firstly, Britain is largely dependent on other countries to support their burgeoning CAD. If in the post-Brexit scenario the flows start to slow down then UK may have a real problem financing the CAD. Secondly, a lot of the clout that UK currently enjoys is due to the positioning of London as the financial gateway to Europe. In the post-Brexit scenario many European and American companies with headquarters in London may not have an incentive to continue with their existing arrangement. The CAD situation could put substantial pressure on the UK£.

How will a weak Pound impact India?

While India continues to trade predominantly with the US, China and EU, a weak UK£ will surely have its repercussions on India. Here are few possible implications of a weak UK£. At a sectoral level, many auto ancillary companies are major suppliers to the European market. A lot of this selling gets denominated in UK£. These could be negatively impacted. Secondly, IT and pharma will face the brunt of a weak Pound. Both these sectors have seen their share of the UK market rise in the last few years. On the one hand, a weak Pound will diminish the value of their earnings and that is already evident from the downgrades that IT companies have been hinting at. On the other hand, a strong dollar and a weak Pound will create cross-currency headwinds for Indian IT companies. Then there are companies like Tata Motors that derive a chunk of their annual revenues from UK based JLR. Such companies could see a real diminution in earnings as a result of a weak pound.

In a nutshell, a weak pound will have larger implications for the global economy. Under normal conditions, a weak Pound would have resulted in higher exports and a revival in economic growth. But, in the aftermath of Brexit it may not work that way. Also the CAD has to be funded and that will come under doubt in the post-Brexit scenario. Not to forget, a weak EU region will apply its own pressure on the UK economy. The sharp fall in the UK£ may just be indicative of a larger inherent problem in the UK economy.

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One response

  1. I like your reports and presentation in a simple language.

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    Like

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