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Graph 1

Brexit and the Rise and Fall of the British Pound

The aftermath of the 2008 global financial crisis, as well as the uncertainty surrounding Brexit’s impact, resulted in several episodes in which the British pound sterling (GBP) plummeted to appalling lows (See Graph 1 below). Following the 2008 global financial crisis, the Bank of England (BOE) and the European Central Bank (ECB) ensued the actions of the United States Federal Reserve in stimulating the economy by initiating Quantitative Easing. QE was implemented after lowering their base interest rates proved insufficient. QE strived to stimulate aggregate demand by participating in three rounds of massive purchases of UK government securities (See Graph 2 below). This relatively new tool attempted to drive up asset prices and therefore lower long term bond yields to stimulate IPO’s and wealth in order to counter deflating assets. With that said, the actions of central banks, such as the Bank of England, to control the money supply, tend to play a role in the value of the country’s currency by impacting the actions of foreign investors.[1] The United Kingdom’s decision to leave the European Union following the Brexit vote in 2016 sparked a great deal of political and economic uncertainty potentially responsible for the pounds intense volatility within the past two years. Since the Brexit vote, the pound has experienced some major episodes in which it depreciated relative to the dollar and euro. This paper will investigate the Brexit aftershock as well as the monetary actions of the BOE.

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Graph 2

The first episode occurred immediately after the results of the Brexit vote on June 23, 2016. Although The UK is not set to leave the EU until March 29, 2019, the euro and dollar price of the pound went into free fall as investors were stunned by the results and grew wary of the economic future of the region (See Graph 1 above and Graph 4 below). The pound had it’s biggest one day fall ranking with the reaction to the collapse of Lehman Brothers and Britain’s exit from the European Exchange rate mechanism in 1992. Investors rushed to sell their holdings of pound sterling, therefore flooding the market and causing the pound to lose about 10% of its Euro and dollar value (See Appendix B). Outpayments in pounds and UK financial assets increased due to worries that the UK’s exit from the EU could hurt profits and companies in the UK therefore damaging London’s attractiveness as a financial hub.[2] At the time the UK economy was still fragile and on the road to recovery following the 2008 global crisis. With that said, the country was in need of a cautious stimulus as it experienced unexpected capital flight, slow annual GDP growth of 0.8% (See Appendix D) from the previous year and a low inflation rate of 0.5% (See Graph 3 below). As a result, the BOE had to intervene.

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Graph 4

Much like the Federal Reserve, the BOE sets its stable inflation target at 2%. The Federal Reserve has remained faithful to their short term interest rate raising plan since 2015 as the U.S. economy continues to steadily expand throughout this business cycle. Meanwhile, on August 4, 2016, the BOE chose to lower rates to a quarter of a percent in order to prevent a feared post-Brexit recession (See Graph 4). The BOE also revived its UK government bond buying program which had been postponed since 2012. By lowering short term rates and continuing QE, the BOE boosted aggregate demand allowing a temporary overshoot of their desired 2% inflation target (See Graph 3 above). CPI appeared to rise as a direct result of the BOE stimulus and the sharp decline of the pound. The monetary policy at the time succeeded in providing a cushion for the UK economy, however in October 2016 the pound experienced another intense episode when it reached a three decade low valuation relative to dollars and euros by October 5, 2016. Investors again began to sell their holdings of sterling and UK assets for other safer currencies such as dollars and euros. The pound’s dollar value was maintained between a range of $1.20 and $1.275 from October and March of 2016 before appearing to begin a sluggish road to recovery (Graph 4).

This sluggish recovery of the pound was fueled by rising inflation levels reinforcing the growing possibility of the BOE raising short term interest rates for the first time in over a decade (See Graph 3 above). In addition to rising inflation, a cheap pound increased the investor’s demand for the currency. As a result there was a slow increase of in payments of pounds into Britain. Investors bought pounds and sold dollars causing the price of the pound to gradually rise over an eight month period from March 2017 until October of that same year (See Appendix C). Along with the gradual rise of the pound, the inflation rate peaked at 3.1% in November following the BOE’s stimulus after the shock of the Brexit vote. With inflation finally overshooting the 2% target, the BOE raised its short term interest rate on November 2, 2017 (See Graph 3 above) to restrain price levels. However, with expectations that the BOE would not raise rates again for a while, investors sold pounds for Euros causing the value of the pound to fall sharply against the Euro. In dollar terms, the pound appeared to rise. In terms of the pound’s Euro value, the pound did not experience any more extreme cases in depreciation or appreciation. However, the pound in terms of dollars, took a major hit in April of 2018 after head of the BOE, Mark Carney, hinted at delaying its short term interest rate raising plan. Although, wage growth had been rising since January Carney relied on other macroeconomic data such as weak retail sales to support his decision of stalling their short term interest rate raising plan.[3] Carney’s decision spooked investors sparking capital flight from Britain once again, causing the value of the pound to fall below $1.40 on April 26, 2018 (See Graph above).

With the third major episode regarding Brexit, Britain experienced unexpected volatility once more. At this point, inflationary pressures continued to linger above the BOE’s target at 2.7%. With that said, the inflationary pressures caused by the recent stimulus remained the biggest worry for the BOE as they chose to raise their benchmark interest rate by a quarter of a percent in August 2018 to its highest level since 2009 (See Graph 3 above). Despite the rate rise, mounting fears that Britain was at risk of crashing out of the EU without a deal provoked a large sell-off of sterling in the financial market. Consequently, the pound fell against all major currencies meanwhile its dollar value hit a 13 month low on August 8, 2018 (See Graph 4 above). The recent speculation in the currency intensified following the statements of the BOE governor and secretary of international trade, Mark Carney and Liam Fox. Carney stated the risk of a hard-Brexit were “uncomfortably high” while Fox declared that there is a 60% possibility that Britain and the EU would not reach an agreement by the departure.[4] Regardless of the weakening pound, the BOE professed that they would not rush to raise short term interest rates. However, the BOE is still on schedule to gradually raise rates as they continue to slowly dampen down the stimulus. Meanwhile the U.S is following a similar path regarding monetary policy while the ECB is slightly behind as they still hold subzero short term interest rates (Appendix A), in addition to the uncertainty regarding their QE program. From August to November 2018 the pound experienced increased volatility as investors’ expectations over Brexit fluctuated between being fearful and hopeful. November has seen a drop of the pound following the recent resignation of six members of Theresa May’s cabinet further deepening the political turmoil in Britain and the EU.

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Graph 5 Source: Office for National Statistics

There are numerous debates surrounding what a weak pound will do to both the financial and real economy. In theory, with a weaker pound, the UK’s exports should become cheaper therefore increasing the quantity of goods and services exported. Meanwhile, imports become more expensive resulting in a decreased quantity of goods and services imported. With that said, these should improve the region’s current account deficit which currently sits at 74 billion pounds (See Graph 5 above). However, Britain, who has become extremely reliant on imports to produce its goods could experience supply shocks due to high tariffs on foreign goods causing inflation to rise. Higher inflation could cause the value of the sterling to depreciate even further allowing for more capital flight out of Britain. Further depreciation of the pound could make it harder for the country to finance its capital spending as it is a large borrower.[5] As Brexit approaches it seems increasingly likely that the UK and the European Union will not be able to reach consensus and develop a deal that allows the UK to remain in the EU’s single market. With that said, the UK could impose more tariffs on imported goods risking further inflation.

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Graph 6 Source: Office for National Statistics

In contrast to manufactured goods, the UK’s service sector, their most important economic sector, might not be as affected by a falling pound. The country currently runs a financial service surplus of about 40 billion pounds (See Graph 6 above). As long as Brexit deals allow for EU financial workers to be allowed for work in the UK, the country could continue to see a rising surplus within the financial sector. However, without a complete trade deal between the UK and EU that covers financial services, companies would risk losing passporting rights. This could potentially force firms to shift all their employees, clients, and assets from the UK damaging the region’s strong financial sector. The city of London, the world’s leading financial hotspot, could be set to lose up to 5000 financial jobs and 800 billion pounds by the time the UK leaves the EU[6]. As a result, London could lose its title as the leading financial sector as financial services are relocated to Frankfurt. Loss of skilled financial labor pool would destroy this segment.

In conclusion, the pound sterling as well as a variety of other currencies are highly responsive to various factors resulting in unpredictable volatility. As of now the United Kingdom finds itself in a tough situation. Resulting from the Brexit vote, they are facing a faltering pound and risk London losing its elite ranking in the financial world. Business investment has also been on the decline as a result of less foreign capital inflows and higher costs of imports. Rising costs of imports would further appreciate the recently stimulated inflation rate. The Bank of England is acting by gradually raising their base rate to try to bring inflation back down to a sustainable level. Moving forward, it will be interesting to see whether the European Union and the UK will come to a free trade agreement and how the ongoing negotiations and continuing monetary actions will impact the value of the pound. As of now, investors expect that the two regions will fail to compromise on a deal before the UK’s departure. Meanwhile Britain might have to consider more unorthodox alliances with the U.S.[7] With that said, we may continue to see a depreciation of the pound and the potential need for a monetary stimulus intended to prevent the real economy from facing a post-Brexit collapse.

Appendix

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Appendix A
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Appendix B
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Appendix C
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Appendix D

Works Cited

[1] Nguyen, J. (2018, November 15). 5 Reports That Affect The British Pound. Retrieved from https://www.investopedia.com/articles/forex/11/five-reports-affect-the-pound.asp

2 Bird, M. (2016, October 05). Pound Drops to Three-Decade Low Against Dollar on Brexit Concerns. Retrieved from https://www.wsj.com/articles/pound-drops-to-31-year-low-against-dollar-on-brexit-concerns-1475566159.

[3] https://www.theguardian.com/business/2018/apr/26/how-has-the-brexit-vote-affected-the-economy-april-verdict

[4] Elliott, L. (2018, August 08). Sterling falls against dollar and euro amid fears of no-deal Brexit. Retrieved from https://www.theguardian.com/politics/2018/aug/08/sterling-falls-against-dollar-and-euro-amid-fears-of-no-deal-brexit

[5] Radcliffe, B. (2018, November 26). What causes a currency crisis? Retrieved from https://www.investopedia.com/articles/economics/08/currency-crises.asp

[6] Makortoff, K. (2018, November 29). London to lose €800bn to Frankfurt as banks prepare for Brexit. Retrieved from https://www.theguardian.com/politics/2018/nov/29/london-to-lose-800bn-to-frankfurt-as-banks-prepare-for-brexit

[7] Stefanova, K. (2016, October 31). The Rise And Fall Of The British Pound. Retrieved from https://www.forbes.com/sites/katinastefanova/2016/10/30/the-rise-and-fall-of-the-british-pound/#16c4d59615db

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