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2016-02-25 11:03:41
Feb 22nd 2016, 14:06 by Buttonwood
THE pound has dropped to its lowest level against the dollar since March 2009,
on fears that the support of Boris Johnson, London s mayor, for the Leave
campaign has made Brexit more likely. While Mr Johnson s economic adviser,
Gerard Lyons, manfully suggested on BBC Radio 4 s The World at One that the
decline was little to do with Brexit, the facts are against him. The pound fell
against all major currencies and there were no economic data to drive the
change; it has weakened in the past on polls indicating Brexit is more likely.
British assets are less attractive to international investors because of the
possibility of Brexit; those investors may be wrong in their view, but it is
clearly their opinion.
So what, advocates of Brexit might ask. A falling pound is good for exporters.
It can be, although it also drives up the cost of imports; a big fall in the
pound is 2008-09 did not eliminate the trade deficit. The key point, however,
is that devaluation is not normally a sign of a healthy economy; think of
Venezuela or Argentina. When Venezuela devalued three years ago, locals queued
up to buy TVs before they rose in price.
A devaluation is a cut in a nation s standard of living; it costs more to buy
other people s goods (or to go on holiday overseas, as many Britons are about
to do). It can be justified if the currency is being held at an artificially
high level, perhaps because it is in a fixed exchange rate system. Sterling s
exit from the Exchange Rate Mechanism (ERM) in 1992 was broadly a good thing;
the high interest rates needed to keep it within the ERM were economically
damaging. Britain did not (as it had in the past) throw away the competitive
gains by allowing domestic inflation to rise sharply.
But Britain is not in the ERM now. The pound is floating. Our Big Mac index
suggests the pound is undervalued, not overvalued against the dollar. There is
no economic imbalance that this exchange rate move is correcting. And there may
be no gain to exporters; as we recently reported, recent devaluers have seen
little benefit
Both the IMF and the World Bank have highlighted another possible explanation
for the weak performance of exports in countries with falling currencies: the
prevalence of global supply chains. Globalisation has turned lots of countries
into way-stations in the manufacture of individual products. Components are
imported, augmented and re-exported. This means that much of what a country
gains through a devaluation in terms of the competitiveness of its exports, it
loses through pricier imports. The IMF thinks this accounts for much of the
sluggishness of Japan s exports; the World Bank argues that it explains about
40% of the diminished impact of devaluations globally. That leaves many
manufacturing economies in a pickle.
So Britons shouldn t cheer the news. And there may be more volatility to come.
Fitch, a credit rating agency, argues today that
The inherent uncertainty about the implications of a Leave vote may add to
financial market volatility and result in sterling depreciation. Smooth
negotiations towards an exit and concluding a trade agreement within two years
(after which the UK would formally exit the EU) could contain this to the short
term, with Brexit only moderately negative for the UK. But there are material
downside risks to these assumptions. The remaining EU members could attempt to
impose punitive conditions on the UK to deter other countries from leaving. The
UK may seek very tough restrictions for EU citizens coming to work in the UK.
If negotiations were hostile or protracted and the post-EU deal was
unfavourable, the damage to the UK economy through loss of trade and
investment, would be much greater.
While Moody s, a rival agency, has just said that
In Moody s view the economic costs of a decision to leave the EU would outweigh
the economic benefits. Unless the UK managed to negotiate a new trade
arrangement with the EU that preserves at least some of the trade benefits of
EU membership, the UK s exports would suffer. It would likely lead to a
prolonged period of uncertainty, which would negatively affect investment, in
Moody s view. It would also place a significant burden on policy-makers who
would have to renegotiate the UK s trade relations with the EU and other
countries and regions, as well as reconsider other areas such as regulatory and
immigration policies.
Moody s would consider reflecting those threats to the UK s credit standing by
assigning a negative outlook to the sovereign s Aa1 rating following a vote to
exit, pending greater clarity on the longer-term impact on the UK s economic
and financial strength.
A lower debt rating could mean higher funding costs and thus a bigger budget
deficit. Of course, the rating agencies did not cover themselves in glory
during the crisis. So yes, the agencies might be wrong about the negative
economic impact of Brexit; the markets might be wrong; the economists who work
for investment banks might be wrong; your blogger may be getting his
instructions from a sinister man stroking a white cat. But there comes a point
when one has to accept the preponderance of evidence.