hot money flows

What explains the recent
movement of the pound sterling?
Amy Chapman, Gordonstoun School
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The function of
exchange rates 1
• C As many countries have their own currency a system is required to ensure that
when they trade goods and services they are able to exchange currencies.
• C Since 1992 the UK has had a floating exchange rate which means that the value
of sterling in terms of another currency has been allowed to fluctuate according
to market forces i.e. demand and supply.
• C For example, a rise in the demand for sterling, perhaps caused by a rise in
exports or an increase in the speculative demand for the pound, causes an
appreciation in the value of the pound.
• C The demand for a currency comes from the need to purchase the currency of a
particular economy.
• C One of the main sources of demand is exporters of goods and services, but
inflows of foreign investment are a further source of demand.
• C In addition, speculative demand – short term ‘hot money flows’ – or official
buying by the Bank of England (under a managed exchange rate system) are
further sources of demand for the pound sterling.
The function of
exchange rates 2
• C On the other hand, the supply of a currency comes from agents needing to
demand overseas currency in exchange for their own.
• C One of the main sources of supply are importers of goods and services.
• C Also outflows of foreign investment, speculative selling of the currency or
official selling of sterling by the Bank of England are further sources of the
supply of a currency.
• C To assess what explains the recent movements in the pound sterling we
need to look at what influences the demand and supply of the currency.
• C Three main factors are speculation, relative interest rates and relative
inflation rates.
• C If speculators believe that sterling will rise in the future, they will demand
more now to be able to make a profit.
• C This increase in demand will cause the value to rise.
• C If markets see news which makes an interest rate decrease more likely, the
value of the pound will probably fall in anticipation.
• C There are therefore important links between
speculation, the state of the economy and the
exchange rate.
Relative interest rates
• C If UK interest rates rise relative to elsewhere, it will become more attractive
to deposit money in the UK, as depositors will get a better rate of return
from saving in UK banks.
• C The demand for sterling therefore will rise.
• C Higher interest rates cause an appreciation in the currency.
• C This is known as hot money flows and is an important short run factor in
determining the value of a currency.
Foreign direct
investment (FDI)
• C Foreign direct investment is a direct investment into production or a
business in a country by an individual or a company in another country.
• C FDI includes mergers and acquisitions, building new facilities, reinvesting
profits earned from overseas operations and intra company loans.
• C FDI into a country requires the buying of that currency, therefore the more
FDI takes place the more demand there is for that currency thus leading to
an appreciation in that currency.
Exchange rates and
the balance of payments 1
• C Countries that have trade and current account deficits will have to increase
the supply of their currency in relation to the demand for it.
• C The value of their currency is therefore likely to fall. The Figure shows the
value of the pound to the euro over the last five years.
• CThe value of the pound has depreciated from £1 = € 1.36 to
£1 = € 1.16.
• CFollowing the significant
depreciation up to the end of 2008
the value of the pound to the euro
then steadily appreciated until the
middle of 2012.
• CWe can see that from the middle of
2012 until early 2013 there was
again a depreciation in the pound to
the euro from £1 = € 1.28 to
£1 = € 1.13.
Exchange rates and
the balance of payments 2
• C The Figure shows the value of the pound to the US dollar over the last 5
years, where the value of the pound has depreciated from £1 = $2 to £1
= $1.55.
• C Again we can clearly see the effect of the credit crunch in 2008 on the
sterling/dollar exchange rate.
• CDuring 2009 the pound
appreciated against the dollar
from £1 = $1.36 to £1 =
• CFrom 2008-2013 changes in the
pound sterling against both the
euro and the dollar represent a
significant departure from the
decade of relative stability for
sterling before the crisis.
The start of
the economic crisis
• C In 2008 there was great concern about the adverse consequences of the
financial crisis on global economic growth prospects.
• C However, for this to account for sterling’s depreciation it required that
investors believed the crisis would have a more negative effect on cyclical
growth in the UK than in other countries.
• C One of the reasons for this was that it was thought that the UK would fair
worse because of the high levels of household debt in the UK compared to
other countries.
• C In addition UK domestic growth for 2009-2011 was revised down more
than in any other country facing these problems.
• C Another factor behind sterling’s depreciation related to movements in
inflation rates across countries and after 2008 the UK inflation rate
persistently exceeded corresponding rates in the USA and the eurozone.
• C According to the theory of purchasing power parity, the nominal exchange
rate would tend to depreciate in order to keep the real exchange rate
broadly unchanged.
• C As we saw in the Figures for the pound/euro and pound/dollar exchange
rates, the appreciation of the pound against the euro was more apparent
than with the pound against the dollar.
• C One of the main reasons for the appreciation of the pound against the euro
was the economic crisis in Greece. In this case it was less about a
strengthening of the pound but more a weakening of the euro.
• C The big question was would the euro survive? This caused panic in the
markets and led to a selling of the euro leading to an appreciation of the
• C But in March 2010 the prospect of a hung parliament following the UK
General Election sent sterling falling sharply against other major
• C The worry was that a hung parliament would cause huge problems in the
efforts to deal with the UK’s economic problems.
• C Once again in the middle of 2012 the UK inflation rate rose above the rates
in the US and the eurozone.
• C This is likely to have been one of the causes of the depreciation of the
pound against these two currencies.
• C The UK also continues to have a very high debt to GDP ratio of any country.
• C Comparing UK and US growth rates in 2012, the UK headed back into
recession while the US continued to have positive growth.
• C This differences in the economies will have led somewhat to the
depreciation of the pound as there will have been less confidence in the
UK economy at that time.
• C In February 2013 the UK lost its AAA credit rating and because of this the
value of the pound fell.
• C Confidence about the prospect of recovery of the UK economy was not
high and investors felt if best to sell pounds and thus the pound sterling