IT'S NOT yet on a par with the near-bankruptcy of 1976, but as the pound has crumpled to record lows in recent days there is an increasing sense that the UK could be heading towards its worst currency crisis in more than three decades.
Although experts are far from unanimous on the gravity of the situation, none can deny the sharp decline in sterling's value: against the standard trade-weighted basket of currencies, it has fallen by more than 20% during the past year. More eye-catc
hing has been its slump versus the dollar and the euro, with the latter hitting an all-time high against the pound after the UK currency posted four consecutive days of losses last week.
With the Bank of England all but certain to continue slashing interest rates to revive the moribund economy, it's difficult to see where any support might emerge for the battered pound. Economists and analysts are reluctant to call the bottom of the decline, even though some commentators have raised the prospect of hitting parity with the euro.
"It may well be the start of a crisis," says Mark Deans, a London-based dealer at currency specialist Moneycorp. "All the data on the UK economy right now is grim – there is no confidence at all."
Others such as Peter Spencer, economic adviser to the Ernst & Young Item Club, argue that the fundamentals don't justify further drastic falls in the value of sterling. Though the UK economy is struggling, other countries are facing similar difficulties.
However, even those of a more optimistic bent admit that the psychology of negative sentiment could prove a self-fulfilling prophecy.
"In the short term, it is very difficult to predict what will happen," Spencer says. "The markets have a mind of their own."
The eurozone's central bankers cut interest rates to 2.5% earlier this month, bringing the overall reduction in rates to 175 basis points since the beginning of October. UK rates currently stand at 2% after the Bank of England slashed the cost of borrowing by three percentage points during the past three months.
A run of exceptionally poor UK economic news has raised speculation that the Bank of England will cut the cost of borrowing further, with some predicting interest rates could hit zero. By contrast, many believe the European Central Bank will move more cautiously on future cuts, particularly after hawkish comments last week from ECB member Juergen Stark.
"The remaining room for manoeuvre is very limited, potentially allowing for small steps only," Stark said on Wednesday.
This is significant in that investors are drawn towards stronger currencies with the higher-yielding returns linked to higher interest rates. Though a shift out of sterling would further undermine the value of the pound, Chancellor Alistair Darling has made it clear that the Government's primary concern is to spur on economic activity.
"Our policy, the Bank of England's policy, is to target inflation, not to target the currency," Darling said last week, adding that the pound's weakness "clearly does help our exporters".
Under normal circumstances, it is a given that a decline in the value of sterling boosts the coffers of companies selling goods abroad, as their wares become more affordable overseas. However, weakening demand around the globe has so far offset most of the benefits of the pound's decline, as is clear from the latest monthly industrial trends survey from the CBI.
Between November 18 and December 3, manufacturers surveyed by the CBI reported that their production expectations remained mired at the weakest levels seen since 1980. Perceptions of overseas demand were far from upbeat, with just 12% of manufacturers saying order books were higher than normal, compared with 45% who said they were below normal. This was despite the fact that sterling has lost about one-fifth of its value during the past year.
"Maybe (the pound's weakness] will balance things up a bit, but it is not a very positive picture at the moment," says CBI spokesman Stephen Cooke.
However, Spencer argues that exporters have been able to restore some of their profit margins, which have been "cut to the bone" in recent years. Though the effects of a weak pound have so far been muted, exporters could eventually benefit if the global economic situation stabilises while the pound remains at lower levels. "If that happens, they will ultimately be the winners," Moneycorp's Deans says.
Other businesses likely to benefit are domestic tourist operations as more people opt to holiday closer to home. Day-trippers and those seeking weekend breaks from the continent should also be lured by favourable exchange rates, similar to the popularity of New York shopping trips among UK travellers last year, when the pound's strength against the dollar made goods in the US relatively cheap.
With the pound now at its lowest since the launch of the euro in 1999, some travel operators are already reporting a rise in the number of Europeans coming to the UK. There is also evidence of increased spending by visitors from the US, as sterling has lost nearly a quarter of its value against the greenback during the past year. Such increases could provide some respite to the battered high street, where retailers are struggling amid a clampdown on spending by domestic consumers.
The flip side to the exporting equation is that a weak pound puts up the cost of both raw materials and finished goods brought into the UK. Under normal circumstances, this would be a significant concern, as rising costs would push up inflation. However, shrinking economic activity should continue to outweigh currency weakness, keeping the pressure on inflation downwards.
Spencer says retailers will find it all but impossible to pass on any increase in costs, forcing more to follow the likes of Woolworths and MFI on the path to demise. "Manufacturers and retailers will have to take the hit on their margins," he says. "They will not be able to pass on those costs to any great extent."
Howard Archer, chief UK and European economist at IHS Global Insight, agrees that recessionary conditions will dampen any spark to the fuse of inflation. "It will obviously be the retailers that will have to take some of the hit, and probably the exporters as well," he says. "Exporters into the UK will want to bolster their own margins, but looking to the long-term, they will also want to keep their markets open when things improve in the future."
Archer is among those who believe that the fundamentals don't support further a significant decline in sterling's value. Despite the recent hawkish comments from the ECB's Stark, Archer says more "appalling" economic data from the eurozone would eventually force the ECB into further significant interest rate cuts.
"Obviously the UK economy is in a pretty poor state, but it's just as obvious that most other economies around the world are in a bad situation as well," he says, arguing that the pound shouldn't reach parity with the euro.
"But I would never say never – these things can become self-fulfilling. If you get enough people talking about the possibility, then that in itself could send it down to parity."
Deans says the only possible source of support for the pound in the short-term would have to come from the Bank of England in the form of strong hints that UK interest rates had now hit bottom. But this is highly unlikely. More probable is the release of further grim unemployment or housing market data, which could make parity "a realistic possibility".
"That begs the question, do we join the euro ourselves?" say Deans. "It does make it easier for a Government – not necessarily this Government – to push us in that direction."
Spencer says the euro question is difficult, but no matter which way it is viewed, joining during the current global turmoil would be the wrong move. "But ultimately, you can't expect manufacturers to live with a pound that is worth $2.10 one minute and $1.40 the next minute," he says. "That is absolutely insane."
Archer believes there is no chance the UK will opt into the euro. He says there is no economic evidence that weighs heavily either for or against joining, and in the absence of a convincing argument, political parties are unlikely to adopt such a divisive issue as part of their manifestos. "I would bet my life that we won't be joining the euro during my lifetime," he says.
He believes the only short-term respite for sterling lies in the hope that the UK begins to show signs of slowing economic decline, making the pound a better bet than currencies from other regions still on a downward spiral. "A lot of it will come down to the relative performance of all the economies."
Deans says the current situation could not yet be compared to the sterling crisis of 1976, which forced Labour Chancellor Denis Healey into the humiliating step of having to borrow £2.3bn from the IMF. With the global recession escalating demand for IMF aid around the world, it is most unlikely we will see that again.
But from Deans' vantage point on the dealing floor, the outlook is grim. "Regarding the fundamentals of the data, there is nothing out there right now to support the pound," he says. "Really, we are waiting with bated breath to see how low it can go."
The full article contains 1601 words and appears in Scotland On Sunday newspaper.
