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On the Road to a Sterling Crisis?

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On the Road to a Sterling Crisis?

September 26, 2016

In the post-war period, the United Kingdom has been no stranger to wrenching sterling crises. Indeed, it experienced such crises in 1967, 1976, and 1992. This makes it all the more difficult to understand the current complacency in UK academic and policymaking circles about the likely fallout from a “hard” Brexit out of the European Union.  This is especially the case considering that Brexit is now taking place at a time that the UK suffers from acute external vulnerabilities that heighten the chances of yet another sterling crisis.

An indication of the UK’s external vulnerability is its gaping external current account deficit, which is now running at a staggering 7 percent of GDP. This is the largest such deficit that the country has had in the post-war period. As Bank of England Governor Mark Carney has put it, such a large deficit makes the UK uncomfortably dependent on the kindness of strangers for its financing.

An important risk that a hard Brexit poses is that it might make foreigners less inclined to continue financing such a large deficit. An early indication of such likely reluctance was to be seen in a more than 10 percent drop in sterling in the immediate aftermath of the Brexit vote last June. It is also now to be seen in sterling’s renewed slide over the past few weeks as the market’s perception of the likelihood of a “hard” Brexit has increased.

There would seem to be at least two reasons to think that market fears about the consequences of a hard Brexit for continued large capital flows to the UK are not misplaced. The first is that if the UK were to lose ready access to Europe’s single market for its exports, the country would lose its attractiveness as a location for foreign companies’ European investments. This was precisely the point made by the Japanese government at a recent G-20 meeting when it publicly warned its UK counterparts of the likelihood that Japanese companies would relocate out of the UK in the event of a hard Brexit.

The second reason is that a hard Brexit would almost certainly result in the loss of the “financial passport” that City of London financial institutions now enjoy for accessing the European market without having to jump through additional regulatory hurdles. A recent Financial Conduct Authority report suggested that as many as 5,500 UK financial firms could be affected by such a loss of passport rights. Meanwhile, major international banks including JP Morgan Chase and Goldman Sachs are warning that, in the event that the City does lose its financial passport, they will need to conduct at least part of their European operations from outside the United Kingdom.

A key point that those in favor of a hard Brexit choose to overlook is that a rapid drying up of foreign capital flows to the UK would have dire consequences for domestic living standards. Not only would a further currency swoon raise import costs and increase inflation. Rather, domestic economic policy would likely need to be tightened both to contain inflation and to make room for a large narrowing in the external current account deficit that foreigners would no longer be prepared to finance. As a result, UK households would be forced to painfully reduce their consumption levels while businesses would be forced to cut back on their investment plans to the detriment of future UK economic growth prospects.

In 1967, immediately after sterling’s 14 percent devaluation, Harold Wilson, who was then prime minister, made the celebrated gaffe by assuring voters that nothing much had happened to the “pound in your pocket”. One has to wonder whether those UK cabinet ministers now in favor of a hard Brexit, who now seem to be gaining ascendancy in Theresa May’s cabinet, are not repeating Harold Wilson’s mistake of minimizing the economic damage that a further sharp fall in the pound might wreak. The UK’s own painful experience with sterling crises would underline how economically destructive such crises can be. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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