Thursday 30 March 2017

Sterling slump raises fears of Brexit-driven currency crisis

Black Friday for the City as sterling heads towards crisis territory. Photo: Bloomberg
Black Friday for the City as sterling heads towards crisis territory. Photo: Bloomberg

Jamie McGeever

Two days ago analysts wondered whether the euro would hit 90 pence by the end of the year - a level it blasted through yesterday morning.

This week's sterling's slump to its lowest in over 30 years has raised fears that Britain's exit from the European Union could yet trigger a currency crisis like those of 1967, 1976 or 1992.

By some measures, such as the speed of losses and volatility of its market trading, the pound is showing crisis-like symptoms. Most observers expect it to fall further on the foreign exchanges before it stabilises.

But for a classic 'currency crisis' to unfold, sterling losses would have to choke off the foreign portfolio investments critical to balancing the economy's massive external payments deficit. That risks a spiral of selling of UK bonds and stocks, sinking the currency further, stoking inflation and complicating the central bank's ability to ease credit more if needed to support the real economy.

For investors fearing such a vicious circle there were worrying signs yesterday that overseas holders of UK assets may be losing their nerve. The UK is unusually reliant on international capital and if investors become nervous about owning sterling assets - including bonds, shares and propery - it could spark real problems.

The last three days have seen UK government bonds and domestically-exposed mid-sized stocks fall in tandem with the pound for the first time since the immediate aftermath of the Brexit referendum.

The selling has not yet turned into a rout, however. Few observers are flagging a match with prior sterling crises just yet, even if the economic, political and financial uncertainty unleashed by Brexit is likely to cast a dark cloud over the currency for some time.

The crisis in 1967 saw sterling come off the gold standard and devalue; in 1976 Britain was forced to seek a multi-billion dollar aid package from the International Monetary Fund; and in 1992 billionaire investor George Soros famously "broke the Bank of England" when Britain was ejected from the Exchange Rate Mechanism, the pre-cursor to the euro.

Market veterans reckon for the current turmoil to turn into a crisis, there would have to be clear evidence foreign funds and central banks were losing faith in the UK economy and policy framework, and offloading their UK assets accordingly.

Britain has the biggest current account deficit in the developed world at nearly 6pc of its annual economic output. In the words of Bank of England (BoE) governor Mark Carney, it relies on the "kindness of strangers" to fund the gap.

If that flow of capital dries up, Britain has a problem. This has been the root cause of most emerging market currency crises in recent decades, notably in Mexico in 1995, Thailand in 1997 and Brazil in 1998.

Around 5pc of the world's known central bank foreign currency reserves are in British pounds, the equivalent of more than $350bn, according to the International Monetary Fund.

That is the third largest holding, behind US dollars (63pc) and euro (20pc).

More than half of UK stocks are held by overseas investors, according to Britain's Office for National Statistics (ONS). Foreign holdings were less than 10pc in the 1970s and 1980s, and stood at around 35pc at the turn of the century.

Nearly a third of investors in British government bonds are from abroad, ONS data shows. That equated to £500bn worth at the end of June.

"This is not a sterling crisis, but it has the potential to become one," said Nick Parsons, global co-head of FX strategy at National Australia Bank, and a 30-year veteran of the currency market.

David Bloom, HSBC global head of FX strategy, said investors have not called time on UK Plc. "Foreign holders of UK assets will not be worried, at least not yet. This is an adjustment. Nobody should be surprised. Adjustments can be smooth or they can be rocky, but policymakers will be concerned."

The volatility comes at the end of a tumultuous week, kicked off by Prime Minister Theresa May saying said she would trigger the process to leave the EU by the end of March. Markets took fright, interpreting this to mean there will be a "hard" Brexit with Britain having less access to the European Single Market.

Investors were also taken aback when May criticised the "bad side effects" of the BoE's low interest rates and bond-buying. Aides said she was not trying to influence Mr Carney but some saw the comments as a warning to the Canadian who is in the process of deciding whether to extend his governorship beyond his scheduled departure in 2018.

Alan Clarke, an economist with Scotiabank in London, said sterling's post-referendum fall was set to add up to 2 percentage points to consumer price inflation, which he now thought would peak at 2.6pc in November 2017. So far, the BoE has sat on the sidelines and allowed sterling to find its own level. (Reuters)

Irish Independent

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