Friday, 11 April 2008

Sterling Crisis?

When I cast my jaundiced eyes over the UK economy, with its falling house prices; minus 2.5% on the average house in March alone (annualise that, if you dare!), its ever-increasing debt burden, its cascading redundancies in the financial sector, and the incipient decimation of retail, one question comes to mind – why haven’t we had a sterling crisis yet?

You know, that’s when the pound collapses in value compared to the other currencies and the Prime Minister has to go rushing to the IMF to borrow money.

I mean, the pound is supposed to be a metric of the performance of the economy; and the performance is dire! What titan is holding it up? And how long can he last?

Of course, it is possible to “buy” value for your currency. Put your interest rates up and money will flood into the country so investors can benefit from your generous offering, and this demand puts up the value of the currency. And fair to say: the UK’s base rate, even after yesterday’s cut, at 5.0%, is still quite attractive compared to other large countries/zones: eg, Euroland: 4.0%; USA: 2.25% and Japan: 0.5%. We comfortably outbid them all.

However this “buying” value for your currency is a nasty tiger to have by the tail. You have to keep handing over the cash or the tiger will turn on you. Countries with economies that actually make things (USA, Japan) don’t need to buy value for their currency – it has intrinsic value because it’s backed by the productive capability of the country.

There is another reason the pound still retains some value… asset sales. UK Plc is selling off the nation’s assets at quite an alarming rate. Over a third of our quoted shares are now owned by foreigners; many of our major financial institutions have been taken-over by overseas concerns; city of London property is at least 50% foreign-owned; four of the six big power generators are foreign-owned, and the foreign ownership of prestige domestic property is widely reported – in London only Buckingham Palace seems to be resistant to the Russian mafia.

Of course, New Labour would call this “inward investment” and applaud it as a wonderful thing. But stop to consider the currency implications. When a foreign concern seeks to make a major UK purchase, first they need pounds. So they buy pounds and this pushes the value of the currency up. And the money they spend enters the UK economy and flatters the GDP figures with a one-off boost which pushes the pound up a bit more. Over the last few years we’ve been having a continual shower of these one-off boosts.

Unfortunately once the one-off boost of a major investment into the UK has completed the money conveyor switches into reverse gear. The new foreign owners of the UK company or commercial property want profits they can repatriate, so they start sucking money out of the UK.

This has a negative feedback effect: first with the boost gone sterling starts to fall, and as sterling falls the foreign owners need higher sterling profits to maintain their foreign currency-denominated profitability, so they put prices up in the UK. This causes GDP to fall and hence depresses the pound even more. Of course they wouldn’t be able to put prices up in the UK if there was a strong domestic supplier of the good in question, but since foreign concerns now dominate many sectors (power, property, finance, etc) they have a free(r) hand. They can put prices up and we can’t stop them. (Think electricity, EDF charges more here than in its home nation of France.)

We could hope that the UK’s foreign holdings might offset this downward spiral. But they are shrinking, and profits from concerns owned abroad are not necessarily repatriated to the UK. We are now also a net oil importer for the first time in many decades, and our “invisible” exports are too small to offset our all-too-visible imports.

So I feel that sterling is due to come a cropper, and frankly we deserve it for the way we’ve run the country over the last ten years.

As I’ve said, the top economies have base rates lower than ours. But let’s look some second tier economies (remember the UK has a base rate of 5.0% at the moment); Australia: 7.25%; New Zealand: 8.25%; Norway: 5.25%. And then further down the scale, highest in Europe, Iceland: 15.5%!

Iceland is already desperate to defend the value of the krona which has been sliding for months. Iceland basically “produces” fish and tourism. They import the rest of their needs. A falling krona is a nightmare for them. (Although their “invisible” exports have been quite high. Financial services have been propping up the rest of their economy. They also have substantial geothermal power for domestic use. The financial side is probably a busted flush now.)

It seems likely that as the UK economy slows down and the foreign owners of our major companies and property stop pouring the money in and start to sweat their assets we will need sharply increasing interest rates to prevent the pound from falling quite dramatically due to the double attack on our GDP.

Or we could let the pound fall. Is that a bad thing?

What it is, is massively inflationary. We import the fuel we use in our cars; we import 40% of the food we eat; we import raw materials for our manufacturing industries. On the plus side, our exports would become cheaper for foreigners, and if there were any appetite left for our assets they would also become cheaper. But note we are overwhelmingly an importing nation, not an exporter. We haven’t been a net exporter of tangibles since the 1970s.

To put it bluntly, unless we defend the pound the economy will go belly-up and foreigners will pick through its bones for any choice morsels there might be left.

But if we do defend the pound we face belt-tightening and hardship as we service our massive debts.

It’s a rock and a hard place. We should never have got into this situation.

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