February 17th 2010
Pound’s Fate Tied to EU Debt Crisis
Since the emergence of the debt crisis in Greece, UK policymakers have been once again patting themselves on the back for not joining the Euro. Otherwise, they would currently be in the same awkward position as France and Germany, whose economic might underpins the entire Eurozone and are wondering about if and how they should lend their support to Greece. Given that the Pound has fallen at an even faster clip than the Euro in recent weeks, however, it seems investors don’t share their sense of complacency. What gives?
One might be inclined to posit that the Pound is falling for reasons unrelated to Greece and the travails of the EU. After all, most of the economic data emanating from the UK these days isn’t exactly positive. GDP grew by an abysmal .4% in the fourth quarter of 2009, and the Bank of England, itself, has revised is 2010 projections down to 1.5%. In addition, inflation is creeping up and short-term rates remain low, such that real interest rates (and by extension, the carry associated with holding Pounds) in the UK are effectively negative.
While this alone would be grounds for selling the Pound, a cursory glance at GBP/USD and EUR/USD cross rates reveals that the Pound and Euro are falling in tandem. In my eyes, this implies that investors have impugned a connection between the situation in the EU (i.e. Greece and the other “PIGS” economies) and in the UK. And no wonder, since UK debt levels are as worrisome as any other country, developing or industrialized. Its budget deficit is 13%, slightly higher than in Greece. Private debt is estimated at £1.5 Trillion, or £60,000 per household, which is the highest (in relative terms) in the world. “Then there’s the trillion-pound bank bail-out, the trillion-pound public-sector pension liability, the trillion-pound public debt and those off-balance-sheet private finance initiatives schemes. If you add up Britain’s real liabilities you find that the UK is heading for a total debt burden of several times its GDP,” summarized one analyst.
Of course, this is nothing new. I, myself, have written about the looming UK debt crisis on previous occasions. While such a crisis is still years away, the turmoil in Greece is causing investors to cast fresh eyes on the similarities and differences with the UK, and they clearly don’t like what they see. On the one hand, Britain’s monetary independence means that it can deflate its debt (by simply printing more money), unlike Greece, whose membership in the European Monetary Union precludes such a possibility. While this means that Britain is ultimately less likely to default on its debt, it makes it more likely that it its currency will have to weaken at some point in the future, so that its liabilities remain manageable. Bond investors, then, are right to prefer UK Bonds, but currency investors are equally right to shun the Pound in favor of the Euro.
It seems that Britain’s conception of itself is somewhat flawed. While it thinks of itself as akin to France or Germany (and hence, is quite happy not to be an EU member at the moment), the markets seem to think of it as a Spain or Portugal. The implication is that the markets currently believe that the UK would do better if it was a member of the EU than on its own. Of course, that proposition is debatable (and still unlikely), but it’s worth bearing in mind because it’s what investors apparently believe.
As usual, the BOE remains (perhaps willfully) oblivious of all of this. It is mulling an extension of its quantitative easing program, which is supposed to end this month. This program is responsible for an expansion of the money supply equal to 14% of GDP in 2009 alone! Most economists consider it a dismal failure, and it seems to have succeeded only in catalyzing growth in prices (aka inflation) rather than output (aka GDP). “The suspicion is that the UK government and Bank of England is not worried that the pound remains weak in this repositioning of currencies. They may indeed welcome it. There is no immediate appetite for raising interest rates to strengthen sterling and no point making exports harder by strengthening the exchange rate.” They would be wise to bear in mind, though, that while currency depreciation is useful for devaluing existing debt, it can have the unintended consequence of scaring off investors, and make it difficult to fund future debt.
Currency investors may be ahead of them on this one.