Investment Clock insights

Impact of "Brexit" on sterling


Ian Kernohan

25 February 2016

A free floating sterling is a very important safety valve for the UK economy, allowing it to adjust to a change in circumstances.  Economies within fixed exchange rate systems are less fortunate and attempts to peg sterling to another currency have usually resulted in poor economic outcomes.

Since November, Trade Weighted sterling has fallen around 10%, and is now back to the top of the post crisis range. It had broken out of at the beginning of 2014, as the UK began to pick up some momentum relative to other economies.

 

 

 

 

 

 

 

 

 

The main reason for the fall, particularly in recent days has been the approaching “Brexit” referendum.  Although the market has revised down expectations for interest rates in the UK, we have seen similar moves elsewhere, so Brexit appears to be the most likely reason for the fall.  The UK is a relatively open economy, and has been viewed as an attractive destination for foreign capital.  In part, this has been due to the UK’s membership of the EU, though other factors, such as legal transparency and the UK’s long-standing openness to foreign investment, are also important.  In a Brexit scenario, the capital inflows which enable the UK to sustain a sizeable current account deficit, would come under pressure and sterling would need to fall to offset this impact, at least until the uncertainty lifted. 

 

 

 

 

 

 

 

 

 

While our base case is that the UK does not vote to exit the EU, the referendum is still some months away, so there is bound to be speculation on the outcome.  At any rate, Brexit is a significant risk and the market will try to price in some probability of such an event.

As a major trading nation, cheaper sterling should be a boon to UK exporters.  It would result in rising import inflation, although this will not necessarily cause the Bank of England to rethink their monetary policy strategy, since it is the reason for the decline in sterling which matters, and how long it persists.  At any rate, the impact of currency moves on inflation usually takes some time to work through.  A free floating currency does however, lower the risk of sustained deflation in a relatively open economy like the UK.

The value of your investment and the income from it is not guaranteed and can fall as well as rise. This article is for professional customers only. The views expressed are the author’s own and do not constitute investment advice.