Monday, September 28, 2009

Forecasts for Pound Sterling in 2010

The Pound has been taking a battering in recent years, not helped by a policy of benign neglect by the Bank of England. Despite a 10% appreciation in the first half of 2009, at the end of June 2009(2) the £ERI was around 20% lower than in August 2007.

The Bank of England have suggested that they view the fall of the Pound as necessary - even beneficial. This is for two main reasons:
  1. Underlying Trade Deficit. The UK has been running a persistent current account deficit (importing more good and services than exporting) for the past two decades.(UK Current account deficit) In the past, this trade deficit was financed by attracting capital flows. However, in the post credit crunch economy, these capital flows have fallen. Therefore, the fall in the exchange rate is necessary to rebalance trade. The UK is experiencing a fall in “the long-run sustainable real exchange rate”. The fall in the Pound should help exporters and reduce attractiveness of imports.
  2. Economic Recovery. Part of the Pound Sterling's weakness is due to the perception the financial / economic crisis hit the UK harder than many of our European partners. The UK banking sector is still fragile following the credit crisis and therefore, the Pound is weak to reflect the depth of recession and the likelyhood UK interest rates will stay close to zero for a long time.
In addition to these factors, the other two factors weakening sterling are:
  • Large Budget deficit. Government borrowing is at record peacetime levels. Very high levels of government borrowing can undermine confidence in a currency see: Why National Debt effects Sterling
  • Quantitative Easing is being pursued in UK more actively than elsewhere. The extent of money creation is creating a fear of potential future inflation and this undermines Sterling.
These factors suggest that the Pound's current weakness could remain in the foreseeable future and even worsen.
  • Close to Parity with the Euro
  • £1 = $1.50
However, some such as Barclays Capital are predicting a rally in Sterling. They suggest sterling could rise against the Euro to Euro 1.25 October 2010. Against the dollar it expects a rise to $1.80.

Why Sterling Could Rise
  • Weaknesses in the UK economy are matched in US and Eurozone. We are not alone in having ballooning debt and deep recession
  • The Bank of England seems indifferent to the Pound's fall. But, it is not actively pursuing a weak pound (it also appeared indifferent at the Pound's recovery earlier in the year). It will want to maintain the credibility of UK Monetary policy and could be forced to raise rates should inflationary pressures return.
  • If the UK does recover, interest rates could rise making sterling deposits more attractive.

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