Investor 91

THE INVESTOR

olidays abroad this year

were even more

damaging than normal

to our bank accounts.

The Brexit vote in June

caused an immediate and sharp fall in the

value of the pound on foreign exchanges.

This is because traders expected the UK

to be weaker, and its future to be

uncertain, if it left the world’s leading

trading block, so they switched to

currencies with a more stable outlook.

Unfortunately for those heading for the

beaches abroad, the immediate impact

of sterling’s overnight depreciation was

a significant increase in costs abroad.

What was different about the

aftermath of the Brexit vote was that the

pound moved significantly in a short space

of time.This is unusual; normally it drifts

up and down over months and years,

changing so slowly that for most people

the price impact is lost amidst a sea of

other changes and price rises.

The impact of a sharp and sudden drop

in the value of our currency spreads far

beyond the holiday pound; devaluations

can transform the prospects of a nation.

Currency depreciation should make our

exports more competitive simply because

it makes our products cheaper in foreign

currency terms and therefore easier to sell.

Simultaneously, it encourages people to

buy British rather than foreign-produced

goods, which become more expensive in

sterling terms – or holiday at home rather

than on the Costa del Sol.

The downside is that items that can’t be

produced at home – French wine,German

cars and the rawmaterials from the likes of

China that manufacturing needs – cost

more.These higher import costs normally

fuel inflation, which, in turn, pushes up

exporters’ costs and eventually their prices,

cancelling out the effect of any price cut

from devaluation. But that cycle normally

takes a few years to work through and in

the meantime countries get a boost,which

is why politicians often stealthily encourage

currency depreciation – they see it as a

quick fix for long-term problems.

Balance sheet

Devaluation may be an option on the

table but would present risks for the UK economy. Seek

professional advice before making any investment.

In practice, however, the impact can

be less straightforward than it appears in

economic models. For one thing,

devaluation only works if other countries

allow it to.Alternatively, they can negate

its effects by devaluing too.This can lead

nations down a dangerous path.A series

of competitive devaluations in the 1930s

and the consequent destruction of trade

relations soured relationships between

countries and added considerably to the

problems of the time. In the current era,

efforts to manipulate the value of currency

are the source of considerable tension

between the US and China, China and

Japan, and indeed the EU and the UK. US

presidential candidate Donald Trump’s

rhetoric against trade agreements is fuelled

by the feeling that the system is being

unfairly manipulated.

Only Switzerland attracts sympathy.

Investors have poured money into the

safe-haven country, pushing the Swiss franc

so high it is a serious problem for the

country’s exporters – despite them being

among the world’s most efficient

companies.The government has tried to

weaken its exchange rate, including

removing its peg to the euro, but this has

been largely unsuccessful.

Theworld ismore complex in otherways.

In the 1990s, Britain’s exports soared

following the devaluation precipitated by

our forced exit from the European

Exchange Rate Mechanism. But when the

pound fell similarly sharply after the 2008

financial crisis, history did not repeat itself.

Exports continued to stagnate.

One factor was that the eurozone

was in trouble, so people there were not

buying our goods – or anyone else’s –

irrespective of how much cheaper they

had become. But it also matters what

you are trying to sell. Britain’s exports

in the 1990s were mainly manufactured

goods, where price gives you an edge.

In more modern economies with

high-end products – such as

pharmaceuticals, computer software

or jet engines and most of all with the

export of services – people will pay

what they have to pay because price

matters much less than quality and

performance.As

a rule of thumb, the

more sophisticated the economy, the

less likely it is that devaluation

significantly boosts export volumes.

Lastly, there is the financial impact,

which manifests itself in two ways.One

is that British companies become more

attractive takeover targets because they

have become significantly cheaper to

a foreign buyer.

The other issue is the vexed question

of the budget deficit and the continuing

need for the government to finance

itself through borrowing.A considerable

slice of the monthly gilt auction is

targeted at overseas investors, but they

won’t lend if they think they will be

repaid in devalued pounds – or they

will demand a higher interest rate to

compensate for the risk.

Similarly, there is an added risk from

overseas investors holding UK shares as

the value of dividends is reduced, making

them less appealing. Small depreciations

may be tolerated, but it is a very fine line

and we would be in deep trouble if they

ever thought the UK was deliberately

devaluing. Most countries borrow far less

from abroad than we do, so they can

afford to flirt with devaluation. For the

UK, with its huge budget deficit, the risks

are a lot greater – which is what lay

behind Bank of England Governor Mark

Carney’s warning a few months back that

we depend on‘the kindness of strangers’.

Most countries borrow

far less thanwe do, so

they can afford to flirt

with devaluation

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CURRENCY

ANALYSIS