Pounding The Pound

The fall in value of the British pound is a problem for mainland Europe and will be added to regular talks on exchange rate issues when G7 finance ministers meet in February. In the past year, sterling has lost around 30 percent versus the dollar, 20 percent versus the euro and more than 40 percent versus the yen. Late Wednesday, the pound bounced back to $1.3977 after slipping to a 23-year low of $1.3618. The British pound has fallen to a 7-year low against the US dollar and a record low against the Japanese Yen.

Bank of England Gov. Mervyn King on Tuesday night signaled that the central bank was set to seriously consider buying up a range of assets in coming weeks in an effort to jumpstart stalled lending to businesses and households. He also outlined potential "quantitative easing" measures that could be used to boost the money supply, or effectively print money, in the face of a steep contraction that threatens to take inflation below the central bank's 2% inflation target. The market is afraid that the UK will turn into the next Spain or Greece. Over the past few months, they have been working overtime to inject more stimulus into the economy, but the more that they spend, the worse impact it has on the UK’s fiscal position. Deteriorating public finances has been the primary motivation for the recent downgrades of sovereign debt ratings by Standard and Poor’s. The FSA has dismissed this rumor but that doesn’t mean that the UK can’t be put on credit watch negative which would be one step before a downgrade.

Investors are selling now and asking questions later because a downgrade would mean more losses for the British pound. Whenever a country loses its AAA rating, funds that are mandated to invest in only AAA assets need to liquidate and shift their positions elsewhere. We have seen this with Spain and could see it again with the UK.

Data from the U.K. labor market showed December jobless claims rose by 77,900, while November claims were revised up to show an increase of 83,100 from an initial estimate of 75,700. The U.S. and the U.K. face very similar predicaments, from a deepening recession to a damaged financial system. Both are orchestrating massive bank bailouts and attempting to assist struggling homeowners. Both are ramping up government spending even as they rely on financing from overseas investors. And both countries have central banks that have slashed interest rates and opened the door to unconventional ways of stimulating the economy.investors not only dumped the pound earlier this week, but also shed U.K. stocks and government bonds, sending their yields up. Such a combination, if sustained, would raise the fear that investors are exiting from a host of U.K. assets, creating a vicious cycle that is difficult to arrest.

Investors worry that Britain could end up fully nationalizing more of its banks, adding more pressure on its balance sheet. It already owns 43% of Lloyds and 70% of Royal Bank of Scotland and nationalized lenders Northern Rock PLC and Bradford & Bingley PLC last year.

After a steady weakening in value for most of 2008, it looks like the British pound will be in for continued weakness for at least the first half of 2009. The problems with UK are very similar to the US. But the similarity ends there - pound got trashed but the USD found strength. They both had the unholy economic trinity of problems - high debt, property prices, an overvalued currency. However, the thing that puts the UK on a different plane:

a) UK property prices has been on a more massive over-valuation compared to the US property

b) at least the USD is a reserve currency still, a luxury buffer the British pound does not have

c) the UK is not using the euro, which may offer some protection by being in a grouping, there is very little incentive for any groupings to help out the pound, in fact the entire chain of events may make the UK to hasten the process to adopt the euro... you didn't want to adopt the euro before because of the perceived strength of the pound and the need to have monetary independence, now in extreme weakness, the UK may have little choice but to take on the euro to replace the increasingly decimated value of the pound

d) in terms of debt, US consumers have loaded up on property financing and credit card debts, the situation is not dis-similar in the UK

e) the credit crisis which decimated banks capital in the US is reflective of many UK institutions as London rivals New York in terms as international finance centers, hence the mode of operations and exposure are very similar as well

All said, the British pound should make new lows in the coming weeks and months. Nationalising of banks will be a hot topic in both US and UK. Talks of adopting the euro and dumping the pound will take on greater fuel.

p/s photos: Elanne Kong Yuk Lam