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Currencies and economics - Don t cheer a devaluation

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.