What explains the recent movement of the pound sterling? Amy Chapman, Gordonstoun School To see more of our products visit our website at www.anforme.co.uk 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. Speculation • 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 = $1.70. • 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. 2009-2012 • 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 pound. • C But in March 2010 the prospect of a hung parliament following the UK General Election sent sterling falling sharply against other major currencies. • C The worry was that a hung parliament would cause huge problems in the efforts to deal with the UK’s economic problems. 2012-2013 • 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 fell.