articles | 26 June 2016

Cyprus and the expat pound – the sequel

Before the referendum I wrote a piece on what might happen to the expat pound in your pocket in the event of Brexit. The following is an update based on the events since the referendum.

At the time I noted that Brexit uncertainty had (as of June 16) already pushed the pound sterling down by about 7.2% against the euro since the beginning of the year.

After a lot of volatility on late Thursday night and all day Friday, the pound slid further, with the EUR:GBP exchange rate ending at EUR 1.23  (81 pence per euro). This means that if you are expecting a UK pension or salary at the end of this month, you will be getting about 9.5% less, compared with 7% less than two weeks ago.

I also noted that although we have seen the biggest swing in sterling since 2009, the pound was quite strong last year. Even after Friday, we are still some way from the low of 1.15 (89 pence per euro) achieved in 2011. The lowest point hit on Friday, based on (which incidentally crashed on Friday morning for obvious reasons) was 1.22.

So what happens next? 

Before the referendum I said this:

“Markets cannot bear uncertainty, so the longer it takes to install a new government and sort out trading relations with the EU, the harder it will be for sterling to recover. A fair guess is that it will fall at least to its weakest so far this year (April 7), when it hit 1.24 – 9% lower than on January 1.”

I was close on how far it might fall but I was wrong on how long it would take: it took hours, not months, to reach there.

So what happens next? I hold by what I said before, namely that “it will depend an awful lot on how the country is governed, which, in turn, will affect investor confidence.” For anyone wanting a crash course, I explain at the end why investor confidence is so very important for the pound in particular.

Suffice it to say that things are not looking good when it comes to governance. The investor Holy Grail is a stable government, with clear policies, in a country with social peace. They also like a reasonably strong opposition, so thatif there is a general election, the transfer of power is smooth. The UK lost all of these in the space of 24 hours.

Instead we have a lame-duck prime minister who says he will hang round for another four months, a Conservative prime minister in waiting who seems unwilling to put an end to the uncertainty by giving a clear idea of what comes next (Article 50 trigger, quicker off-the-shelf the Norway option, or long negotiations to try and bargain something different?). We also have an opposition Labour Party in more disarray than ever and we have a country divided both within England and within the United Kingdom.

The longer this goes on, the worse it will be for the pound for reasons explain in full below. One can argue that successive UK governments allowed the country to depend too much on the City and not enough on other goods and services. One can also argue that this helped split the country between the prosperous south-east and the rest.

But addressing that weakness will take decades. For the time being, the pound is in peril and clarity on where we are heading is absolutely essential, otherwise expats dependent on income in pounds are going to see a sharp drop in income.

Crash course follows

Why the pound depends so heavily on investorsI have taken another look at the UK balance of payments since last week and the conclusion remains that things are not that good.

The UK is currently running its largest ever ‘current-account deficit’, at £96 billion, or 5.2% of GDP in 2015. This means it imports more in goods, services and profits repatriated out of the UK than it earns in exports of goods, services profits repatriated back home.

To pay for imports, you essentially sell pounds and buy euros/dollars. The greater the demand, the more you have to pay (81 pence for every euro today compared with 74 pence on January 1), so the weaker your currency gets.

As a big financial centre the UK covers a large portion of its current-account deficit each year with a surplus on the ‘financial account’. Last year, this net flow of foreign direct investment in companies and real estate, bank deposits, stock market investments, debt and derivatives reached £94bn (5.1% of GDP), or an even higher 6.2% if you exclude reserves.

However, in 16 out of the past 19 years the financial account not been large enough to cover the current-account deficit.

In those years the difference was made up either by spending foreign exchange reserves (this happened in 8 of those 16 years), or via another rather vague but rather large category called ‘errors and omissions’.

The errors and omissions represent all the money that has found its way into the country without being officially recorded.

So the bottom line is that the UK already struggles to pay the current-account deficit with money coming in for investment in factories and companies, or trading in the City of London. You can see that it does not take much of a loss of sentiment for the financial account surplus to fall even further.

When that happens, and assuming that the errors and omissions dry up as well because confidence disappears, you have to pay for imports with foreign exchange reserves. This is what happened in the global financial crisis year of 2008.

If foreign reserves dwindle lot, as they did in 1992, then your only choice to stabilise the currency (and prevent soaring inflation as imports become more expensive), is to make the currency more attractive. You do that by jacking up interest rates. This makes mortgages more expensive, kills spending power and is normally followed by a recession.

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