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Understanding the British pound’s sudden crash

Understanding the British pound’s sudden crash

Economic uncertainty is weighing heavily on the British pound against the US dollar and the euro. (Photo: AFP/Niklas HALLE'N)

Britain’s most radical package of tax cuts since 1972, combined with plans for large-scale borrowing, have taken financial markets by surprise and triggered a slump in the pound to a record low.

The unorthodox measures are designed to kickstart economic growth, yet the mini-budget unveiled on Sep 23 raised fears that it could exacerbate inflation, undermine state finances and even cause a full-scale run on the currency, putting pressure on the central bank to step in. 

WHY DID THE POUND TUMBLE? 

The tax cuts went further than economists expected, trimming the top rate of income tax along with corporate tax and other levies.

Liz Truss, who took over as prime minister less than three weeks earlier, is arguing that the changes will turbo-charge the economy, stave off a recession and shake the UK out of a decade of underperformance.

Soon after the plans were announced by her Chancellor of the Exchequer, Kwasi Kwarteng, the pound slid more than 3 per cent to its lowest since 1985. His comment two days later in a BBC interview that there was “more to come” sent the currency briefly tumbling almost 5 per cent further to an all-time low of US$1.0350, before recovering back above US$1.07. 

WHAT'S THE BACKDROP?

The concern is that the burst of fiscal stimulus will exacerbate price pressures just as the Bank of England tries to rein in inflation, which was 9.9 per cent in August, almost five times the central bank’s target and close to a 40-year high.

Investors are also concerned that the new budget will put the country’s debt on an unsustainable path.

State finances were already stretched by emergency spending sparked by the pandemic as well as soaring energy prices resulting from Russia’s war in Ukraine and costs associated with the Brexit vote to leave the European Union. That came on top of many years of low productivity relative to the country’s closest competitors in the EU.  

WHAT'S THE GOVERNMENT'S PLAN? 

The aim is that the tax cuts will create a more dynamic economy, which should eventually generate higher tax revenue and keep borrowing in check.

The new Conservative government's plans have drawn comparisons, even among its supporters, with the ill-fated 1972 budget drawn up by Kwarteng’s Tory predecessor Anthony Barber, who also delivered a massive package of unfunded tax cuts. In his case, inflation soared and the economy overheated before collapsing into recession. Barber’s boss, Edward Heath, was defeated by the Labour opposition two years later, and the UK had to seek a bailout from the International Monetary Fund in 1976.

There are also parallels with policies followed in the 1980s by another of Kwarteng’s predecessors, Nigel Lawson, under then Prime Minister Margaret Thatcher. 

WHERE DOES THIS LEAVE THE UK'S PROSPECTS?  

An export powerhouse like Japan is better able to manage a bout of currency weakness thanks to its huge current-account surplus.

The UK is in a similar position to some emerging markets, with one of the largest current-account deficits in the world and an already sizable budget deficit - set to get larger after Kwarteng’s announcement. Inward investment into UK property and other assets tend to prop up the pound in normal years.

But with growth weak and the economy increasingly volatile, there are mounting reasons not to invest in the UK. Lawmakers from Truss’s party have said the Bank of England may need to step in with an emergency rate rise to calm market nerves. 

WHY DOES IT MATTER?

Truss' Conservative Party, which has held power under four prime ministers since 2010, will face a general election by January 2025 at the latest. That gives her little more than two years to convince voters that her policies will work and the country’s cost-of-living crisis will abate.

While she retains a comfortable majority in the House of Commons for now, the party is trailing the opposition Labour Party in opinion polls. A continued decline in the pound would pile further pressure on the government.

Option-market pricing in late September suggested a real chance that the currency will hit parity with the dollar before the end of 2022. 

Source: Bloomberg/vc

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