The tanking of the British Pound
The British Pound has been in the spotlight in the last couple of weeks for its dismal performance in recent days. This week got worse as the currency crashed to a record low against the US dollar on Monday on growing fears about the stability of UK government finances.
During trading in Asia and Australia on Monday, the Pound plunged by nearly 5% to just above $1.03 and extended a 3.6% dive from Friday. At one point in Asian trading, the pound sank as low as $1.0327, surpassing the previous record low reached in 1985. The price of 5-year UK bonds recorded the sharpest fall since at least 1991.
Analysts have pegged the decline on an announcement that the British Chancellor of the Exchequer Kwasi Kwarteng’s made on Friday that the United Kingdom would implement the most significant tax cuts in 50 years while boosting government borrowing and spending in the face of high inflation. Confidence among investors on whether new Prime Minister Liz Truss’s economic plans would bring stability to the region is low, hence the selloff of the currency.
What has caused the pound’s recent decline?
The current decline in the Pound began on Friday, 23rd September when the pound lost 3.6% following an announcement that the British Chancellor of the Exchequer Kwasi Kwarteng that the United Kingdom would implement the most significant tax cuts in 50 years while boosting government borrowing and spending in the face of high inflation.
According to Kwarteng’s announcement on Friday, the UK proposed massive tax cuts that included abolishing the 45 percent tax rate on incomes over 150,000 pounds. These tax cuts alongside a plan to support households in dealing with their rising energy bills would require the British government to borrow an extra 72 billion pounds in the next six months alone.
The selloff that followed this announcement indicated that investors are concerned about the UK’s ability to manage so much extra debt, especially as rising interest rates make borrowing much more costly.
Another reason for the weak pound, according to analysts, is the ever-rising value of the dollar. The dollar has been on an upward trajectory since mid-2021 and even hit a 20-year high against six major currencies last month.
As global economies continue to struggle, led by the UK, the US economy continues to gain more confidence among investors relative to its peers. Investors are dumping the GBP for its USD counterpart as a result. While the US economy is battling high inflation and flagging growth, it is viewed as being on a stronger footing than economies such as the UK and the Eurozone, both of which are widely thought to be in recession.
What should the UK do to tame its economic decline?
The Sterling continued to fall on Wednesday morning until the Bank of England (BOE) said it would step in to prop up the gilt market by buying as many long-dated government bonds as needed between now and October 14th to stabilise financial markets, and added that it would postpone next week’s start of its gilt sale program. This move immediately reduced long-dated bond yields back to their level at the end of Friday but shorter-dated yields were still higher. Prices in the UK gilt market also rose, indicating a positive uptake of the news by the market.
The BOE pledged to buy around 65 billion pounds ($69 billion) of long-dated gilts after the new government’s tax cut plans triggered the biggest sell-off in decades. The postponed gilt sale program by the bank was set to sell down its 838 billion pounds ($891 billion) of government bond holdings. The confidence is however not unanimous among investors, with the bank still committed to an 80 billion-pound cut over the next 12 months in its holdings of bonds bought after the global financial crisis of 2007-08 and during the COVID-19 pandemic.
Analysts also believe the UK oughts to raise interest rates to US levels, with public calls from some economists for emergency action being recorded. With Japan being faced with a lesser painful version of the British economic slump, both the Bank of England and the Bank of Japan can decide to raise rates to match the rising US interest rates. This will help if the hikes are larger than expected, otherwise, a small hike won’t help much with the currency values. The risk with aggressively large interest rate hikes is that it’s likely to push the economy into a recession.
Another solution, though not widely popular, would be the UK government buying up their own currency to prop up its value, although this is frowned on by many countries and risks invoking trade penalties.
As the currency continues on a volatile trade, it will be interesting to see how the pound and the UK economy handle this historical slump.