What Next For The British Pound?

Posted on: 05 January 2009 by Gareth Hargreaves

After a calamitous drop in 2008, we digest the full fall out from a weakening British Pound.

The strength of sterling has become a major issue for most households. As the pound has dropped in value against other major currencies like the American Dollar and Euro, travelling abroad has become much more expensive.

Imported goods are also going up in price and British expats who live - or are thinking of moving - abroad are seeing their spending power significantly reduced.

Here we explain what determines the strength of the pound and examine the future of a weakening British Pound.

What Happened To Sterling In 2008?

The pound began the year worth €1.359. It declined sharply to €1.235 by mid-April, stabilised for six months and then suffered a calamitous drop from the start of November to its current level of €1.022.

That’s a fall of nearly 25%.

Against the US dollar, sterling began the year at $1.985 and, hitting a peak $2.022 on the 12th March, held its own until August.

It then began a rapid descent to $1.467 by mid-November, which is roughly where it currently stands having hovered around the $1.500 mark.

What Determines The Strength Of Sterling?

Sterling is a freely floating currency, so its exchange rate - its price in terms of another currency - is determined by supply and demand.

Simply put, the more the pound is in demand internationally, the stronger its exchange rate will be.

Probably the biggest single factor affecting demand for the pound is the economic health of the UK - or rather, how the market expects the UK economy to fare in the near-future. This is because investors tend to move money out of weakening economies.

The sudden worsening of expectations for the UK economy during 2008 goes a long way to explaining sterling's precipitous decline.

Alongside this is the level of - or expectations for - UK interest rates. A higher interest rate means a better return on bonds, gilts and other Government securities and therefore tends to attract financial capital from overseas.

If currency markets expect the UK base rate to fall, the pound will tend to weaken.

A currency is also likely to weaken in order to correct a large trade deficit - which is unsustainable in the long-run - by making exports cheaper and imports more expensive.

These domestic factors do not act in isolation: the exchange rate of the pound is determined relative to the situation in the other currency's host economy.

As the US economy emerged from its crisis in 2008, and as the onset of a recession for the eurozone has thus far been deferred, the pound has fared badly relative to dollar and euro.

And if, for instance, the European Central Bank suddenly cut rates - as many expect it to in 2009 - the Euro should lose some of its strength versus sterling.

The Impact Of A Weakening Pound

The most immediate effect for most households is an increase in the cost of travelling abroad. As one pound buys less of a foreign currency, overseas hotels, goods and services will become proportionately more costly.

This also means that imported goods to the UK become more expensive, which also hits businesses that import a lot of raw materials or components as part of their production process.

Exporters who price their goods in sterling meanwhile will benefit as their goods become cheaper in overseas markets.

The UK tourism sector should also win, with Americans and Europeans finding British trips at their cheapest for 20 years.

On a macroeconomic level, many economists have deemed the devaluation of sterling as a necessary boon to the UK economy, which is running an unsustainable long-term balance of payments deficit.

The correction to the pound will, they argue, rebalance the economy away from a debt-led import-guzzling consumer boom.

Will the Pound recover? Whose to blame for the drop in sterling?

Let us know by leaving a comment in the box below or share your thoughts with other readers in the 50connect forums.

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