Sterling – far from flash

Even before last night’s “flash crash”, which saw it reportedly trade as low as $1.14, sterling was having a torrid week. And while it is currently 10 cents or so above where it traded at the lows overnight, at below $1.24 it is still down 4.5% since last Friday’s close, making it the worst-performing of all currencies in the world over the past week. And, even over a longer time period, sterling now sits among a sorry band of currencies in terms of performance - since the start of the year only the currencies of Angola, Sierra Leone, Nigeria, Venezuela, Mozambique and Suriname have fallen by more. 

Best and worst currencies against USD this yearBest and worst currencies against USD this yearSource: Bloomberg

That, of course, is a proper rogues' gallery of countries facing, variously, war, disease and economic collapse. But it starkly highlights the extent to which investor confidence is being shaken by Brexit. The falls in the past week came on the back of the Conservative Party conference, where more details on what sort of Brexit the Government will be pursuing were revealed. The headlines were, of course, grabbed by Theresa May’s promise to trigger Article 50 by the end of March. But of more importance was that the approach she and other members of her Government outlined over the week suggested that a hard Brexit, whereby the UK will leave the EU without any new trade arrangements in place, is the more likely outcome. Certainly, she indicated that the control of EU immigration is the number one priority for her Government, something that other EU Leaders have repeatedly said is incompatible with single market membership.

Once the UK triggers Article 50, the outcome is largely out of the Government’s hands – the two-year negotiation period is set out in the EU Treaty and can only be extended with the unanimous approval of all other 27 EU countries. Given that those countries now just want to see Brexit completed as quickly as possible, and are also keen to ensure that the UK pays a price for leaving the club, a sympathetic hearing for Theresa May and an extended negotiation period seems highly unlikely. As such, the UK seems hell bent on a course that will see the UK leave the EU at the end of Q119 with no trade deal in place. 

The renewed weakness in sterling therefore makes sense - the UK runs by far the largest current account deficit of any major economy and needs capital inflows from abroad worth 6% of GDP or so to finance that. Those inflows are clearly going to be less forthcoming in a world in which significant doubts about the UK economy's future growth have been raised by the prospect of hard Brexit (as well as the strident anti-immigrant/anti-foreigner rhetoric that was so prominent in so many Ministers’ speeches at the conference). Certainly foreign direct investment flows (the UK has in the past received about half of the FDI flowing into the EU each year, largely to allow firms to access the EU’s Single Market) will fall sharply. Already Nissan has said that it will invest no more in its Sunderland plant, which accounts for one third of UK auto production, until it knows what Brexit will actually entail or is compensated for any additional costs incurred, and this is a decision that is being repeated in boardrooms up and down the country (and beyond).

Indeed, hard Brexit implies that the UK will probably leave the EU without a trade agreement in place to replace the current completely free-trading access that UK firms have with the destination for almost half their exports. A reversion to WTO rules would see tariffs imposed on UK exports to the EU. But, more importantly, it would also impose significant customs costs on firms. That would make the UK a much less attractive place for manufacturers who rely upon the EU’s customs-free arrangements both to facilitate exports but also to implement the sort of just-in-time stock management that is the hallmark of world-class manufacturers.

But at least goods firms will be able to trade under WTO rules. For the UK's financial services and business sector, which runs an annual trade surplus of more than £70bn, EU markets are likely to be closed completely for a large part of that sector in the event of hard Brexit. Outside the Single Market UK-based financial services firms will lose their "passporting" rights that currently enable them to operate across the EU from London. To carry on doing that business, firms will likely need to move those operations that trade with the EU to within the EU. Thing is, take away the UK's surplus in financial and business services trade and suddenly a 6% or so current account deficit becomes closer to 10% of GDP (see chart).

UK current account balanceUK current account balance*Primary and secondary. Source: ONS, Thomson Reuters and Daiwa Capital Markets Europe Ltd.

It’s not really all that surprising, therefore, that sterling's dropping like a stone. And if the hard Brexit rhetoric keeps up, expect it to fall further. Following the UK’s ejection from the ERM in 1992 it took several months for sterling to bottom out (see chart). If sterling takes a similar path this time, that implies $1.15 is entirely plausible. But Brexit is different - the ERM fiasco did little damage to the UK economy’s long-term growth prospects – indeed, by allowing interest rates to fall from their artificially high level growth returned fairly soon afterwards. That will not happen with Brexit, which offers only threats, not opportunities. And the harder the Brexit, the more severe the economic damage will be. Certainly, for foreign investors, the UK now looks a much riskier place to put your money, putting further significant downward pressure on the currency. Sterling’s all-time low against the dollar was $1.05 – if the Government keeps careering headlong into a hard Brexit, a return to those lows is not unimaginable.

Sterling and EU crisesSterling and EU crisesSource: BoE and Daiwa Capital Market Europe Ltd.

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