Readers Question: I read a lot about the Dollar/Pound relationship but I want to know what the forecast is going to be for Euro/Pound. What is the factor that determines the value of the Pound down against the Euro?
The Main factors determining the value of the Pound Sterling to Euro
- Relative interest rates - If UK interest rates are higher than Eurozone, this will attract hot money flows from Europe to UK. This will increase demand for sterling, and sterling will appreciate
- Prospects for economic growth. If the UK economy grows quicker than the Eurozone, we would expect UK interest rates to increase faster than in Euro, causing an appreciation in Sterling.
- Prospect for inflation. If UK inflation is higher than in Eurozone, it will make UK goods relatively less competitive than Euro goods. This will cause less demand for UK goods and a devaluation in the value of Sterling.
- Government Debt. If markets fear government default, this makes them less willing to hold currency which the debt is denominated. If markets feared the UK government may default, foreign investors would sell UK bonds, pushing down the value of the exchange rate.
Reasons Why the Pound Devalued against the Euro in 2008/09
- UK Economy in steepest recession. The UK economy experienced a rapid drop in GDP (Steeper than even Great Depression of 1930s). The UK was particularly hard hit by credit crunch because of the UK's exposure to financial services. Because of the sharp slowdown in UK GDP interest rates were cut to 0.5% in March 2000
Lower interest rates are very important for weakening a currency. Lower UK interest rates make it less attractive to buy Sterling and save the money in the UK. Therefore, there are less hot money flows and a weaker value of Pound.
- Housing Market. The UK Housing Market plays a crucial role in determining consumer confidence, spending and economic growth. The fall in house prices has reduced consumer confidence and with house prices forecast to fall or stagnate in 2012, it is another factor which will keep interest rates low.
- Credit Crisis. The UK is heavily exposed to the credit crisis because mortgage lending accounts for a high % of disposable income. Mortgage lending is more important in the UK than the Eurozone where mortgage payments account for a smaller % of disposable income. With less mortgages becoming available, demand for housing is falling. Also those with existing mortgages are seeing the cost of remortgaging increase. This is putting pressure on the Bank of England to reduce base rates to compensate for the increased bank rates. As they explained the recent interest rate cut:
"The disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target."
- UK Current account deficit. Relative to the EU, the UK is running a current account deficit, which puts downward pressure on sterling because of the outflow of foreign currency. UK's current account deficit is still 4% of GDP (Q3 2011) despite devaluation.
- Large Rise in Government Borrowing. With government bailouts, fiscal expansion and tax cuts, government borrowing will be close to 9% GDP in 2012/13. This causes lower confidence in the UK economy to pay off debt (though UK public sector debt is still lower than many of our European counterparts)
Predictions for Pound vs Euro in 2012
The Euro has become increasingly weak since the onset of the Euro debt crisis in early 2010. Markets fear default in countries like Greece, Italy and Portugal. This could lead to countries exiting the Euro. This uncertainty and fear over default has pushed the Euro lower. There is no quick fix to the Euro debt crisis. Efforts to reduce government borrowing have caused a slowdown in economic recovery and prospects of a double dip recession make markets more nervous over the Euro.
The UK's recovery is being held back by the Eurozone downturn. The UK is highly reliant on the EU for our exports. However, the UK still has greater flexibility than the Eurozone and recovery is likely to be stronger in the UK than in the south of Europe.
The strength of the Euro is also causing problems for EU exporters.
The Pound has fallen on the back of depressing economic statistics. The whole Global economy is likely to experience recession, but, the UK recession has been deeper than most. Against this backdrop the pound has been weaker.
Picture from : Guardian - Pound falls to record low