As the Greek crisis nears some resolution, the question on everyone?s mind is whether a sterling crisis is next on the cards. After all, with high deficit countries in investors? sights, the pound has fallen to a nine-month low against the dollar and a six-week low against the euro, even as Greece descends into national strikes. A crisis can be avoided, but the pound faces both internal and external vulnerabilities that will continue to make investors jittery.
The sterling is beginning to trade like an emerging market currency, and has more volatility than even the Turkish lira, as the threat of a hung Parliament and delays in tackling the UK?s debt mountain have weighed on forex markets. With the latest polls suggesting the Tories will fail to win a Commons majority, experts warn of a full-scale economic crisis unless the general election delivers a clear result. At more than 12% of the national income, Britain?s deficit is now on a par with that of Greece?which has been plunged into a deep financial crisis and social unrest.
A Labour victory would further damage the fiscal credibility of the UK given the party?s reputation for favouring a loose fiscal policy at a juncture when a credible plan is needed to bring down the budget deficit. A ComRes survey for The Independent found the Tory lead narrowing to five points in the past month, which would still see Labour return with the most MPs, under the first-past-the-post system. A YouGov survey for The Sun has given the Tories a seven-point margin. That was well up on the weekend but still short of the double-digit lead Mr Cameron needs to be confident of a Commons majority.
Uncertainty is always a bad thing for a currency, and at the moment, there?s uncertainty about the uncertainty. A collapse in confidence in Britain, experts fear, would trigger a full-scale run on the pound, drive up interest rates and undermine the recovery. In the worst- case scenario, Britain?s gold-standard AAA credit rating on the international markets would be downgraded, massively increasing the cost of financing the national debt. Business Secretary Lord Mandelson, speaking to City leaders recently, conceded that Britain?s public finances have been ?ravaged? by the recession.
There are a few comforting factors. At least the sterling doesn?t suffer from the structural and institutional flaws that the Greek crisis has exposed in the European currency project.
And it is arguably no longer overvalued: the 28% depreciation against the dollar in 2008 means it is close to its long-run average real exchange rate of $1.56.
The sterling?s vulnerability is exacerbated by the widespread foreign ownership of UK assets ?foreign investors own about half of UK-issued bonds. It is subject to variations in global risk appetite. If foreign investors were to lose confidence in monetary or fiscal policy, the sterling could be the main victim. This combination means that any number of flash points could lead to a crisis.
Some believe that overzealous fiscal tightening could send the pound to $1.05 or below but others argue the opposite risk?a failure to tackle the fiscal deficit would hit the pound. Disappointing domestic economic data (from slower growth to higher inflation), a failed gilt auction or a sharp rise in risk aversion could also trip up the sterling.
It is time to start excavating British political history. The sterling is nose diving, and the best parallel may be with its darkest hour, in early 1985, when the pound nearly reached parity with the dollar. The incident only ended with rate rises and an international agreement to push down the dollar. Neither option looks possible now. Margaret Thatcher had an overwhelming majority, but her government could not get its message straight although she was famed for running a very disciplined government. Different factions of the government were not speaking in the same voice. Some refused to go public with their opinion about what the government planned to do with respect to the sterling. One spokesman of the government said that the pound would not be defended if it was sold off, and so the markets aggressively bet against it.
Foreign exchange market movements do not seem to reflect market fundamentals. If there were fresh reasons for concern about fiscal policy, UK bond yields would have risen. But they fell. If there were new causes to fear the government?s ability to fund itself, market expectations for inflation would have risen substantially. But they have not. The brotherhood of currency traders may have become materially more nervous about the political risks of a hung Parliament, but they are catching up with concerns that investors in other markets had already priced in. This fear may weigh on the pound in the coming months, but it will not break the sterling.
Britain?s political problems are simple compared with those of the US, with its structurally hung Parliament, or the split decision-making processes of the eurozone. In truth, a bigger source of uncertainty than the prospect of a hung parliament is the fact that?months before an election is required by law?neither of the main parties has set out a credible deficit reduction plan. Investors do not yet know whether either main party has the political stomach to take the necessary action, and voters do not yet know what their options are. Britain?s deficit is expected to hit about ?170bn ($255bn) this year?the highest among the G-7 as a share of national income?and bond markets are pricing UK debt as if the country had already lost its cherished triple-A status.
Alistair Darling has spent the days running up to his final Budget before the UK general election relentlessly insisting there will be ?no giveaways??as if that were ever an option. With the economy struggling to get off its knees and public finances laid waste by the financial crash, the markets are unlikely to react kindly to a chancellor of the exchequer enticing voters with more borrowed money. He cannot sharply increase borrowing because investors would not bear it: even PM Gordon Brown has moderated his usual requests for Darling to open the public spending taps a little more.
Nor can Darling follow the advice of fiscally hawkish economists?or the Conservative opposition?who want him to start cutting the deficit this year. That would destroy Labour?s central election message that public spending is needed now to nurse the economy back to life. So, he must somehow convince the voters that he has a grip on the economy and brighter horizons lie ahead, while convincing the markets that his heart is in tackling the deficit?not always obvious in previous statements.
If we consider the purchasing power parity of the dollar against the pound sterling, the pound looks to be clearly undervalued. Still, there are many precedents where the sterling was even more undervalued. If the pound were to go below the level it reached in its worst crisis over a year ago, it would be hard to see where this downturn could stop. At the same time, it is hard to see the pound rebounding until the election is well and truly over.
The author is a Wharton Business School MBA and CEO, Global Money Investor
