A tumultuous week for the pound. And there could be more to come. Sterling, at the time of writing, is below $1.24 – down from $1.29 last weekend. The markets are properly spooked.
This latest currency fall was sparked early last week, when Prime Minister Theresa May signaled her preference for “hard Brexit”. But then the pound plunged more. Friday’s “flash crash” – which saw sterling touch $1.18, before recovering – followed warnings from French President Hollande that Britain would “pay” for leaving the European Union. That apparently triggered a wave of automatic, computerized sell-offs.
While sharp currency movements are alarming, sterling has long been overvalued. The pound needed to weaken, if more smoothly and not by so much. It’s also the case that, despite all the sniping, there is much to recommend hard Brexit – leaving within two years of April 2017, May’s new Article 50 deadline, even if no over-arching UK trade deal can be agreed with the EU. Ministers shouldn’t be shy to say that. In fact, they should shout it from the rooftops.
Britain is sporting a huge current account deficit. Our import-export imbalance amounts to 5.9pc of GDP – among the biggest in our peacetime history. A weaker pound helps, as we’ve seen since the June referendum, by making exports more competitive.
British factories registered their best month in almost three years during September, we learnt last week, topping an encouraging post Brexit-vote quarter. The PMI manufacturing index jumped from 53.4 to 55.4 – with results above 50 indicating growth – as export orders surged.
Our service sector, accounting for four-fifths of GDP, is also benefitting from a weaker currency. The September services PMI weighed-in at a healthy 52.9, reflecting a buoyant economy.
Lower sterling, on the flip-side, generates inflation via dearer imports. But at 0.6pc, the growth of the UK’s CPI price index is anyway far too low. I thought the whole point of the Bank of England’s seemingly endless money printing and ultra-low interest rates was to push inflation up? That will probably now happen, the result of a weaker pound.
In 2015, an International Monetary Fund report judged that sterling, based on the UK’s trade and productivity fundamentals, was “overvalued by up to 20pc”. By the end of the year, numerous City analysts were dubbing the pound, then at $1.47, as “the world’s most over-valued currency”.
The fall to just below $1.27, then, where sterling was before Friday’s weird “flash crash”, isn’t surprising given our external deficit – and is well within the IMF’s previous estimate. That’s not to deny the impact of sharp currency swings on business sentiment, but to highlight that the pound is reflecting economic realities – even if this latest drop has been overdone, thanks to political fervor, and a bunch of determined traders keen to exploit a thin market.
The danger now is that alarming currency swings and related garish headlines, even at this early stage, derail the UK’s strategy for leaving the EU. For while “hard Brexit” is demonised by many – portrayed as “stupid”, “fatuous” or “Right-wing” – it actually makes a lot of sense.
Hard Brexit means rejecting the notion of joining the European Economic Area – the so-called “Norwegian model”. EEA membership involves continuing our large, multi-billion-pound annual payment to Brussels and accepting numerous EU rules – including “freedom of movement”.
The EEA was created for governments that want to join the EU, but haven’t yet convinced their voters – it’s a membership ante room. The UK, in contrast, is in the EU departure lounge. EEA membership is inappropriate, betraying our referendum result.
While she got close, May didn’t quite rule out EEA membership during last week’s party conference. That was a mistake. If the UK says EEA definitely isn’t an option, we’re rejecting irrevocably any compulsory contribution, freedom of movement and membership of the so-called single market. As long as these big, emotive issues remain on the table, our negotiations with Europe will inevitably become fraught. Hollande’s latest rhetoric would be just the start.
My guess is that talks with the UK, starting with EEA and trying to improve on it, would end in bad-tempered gridlock. Across Europe, here and abroad, faith would be further undermined in mainstream politics. Around the world, following Europe’s grisly example, trade squabbles and protectionism would rise. And the damage to UK-EU relations would be ongoing – reducing the chances of future co-operation, once we’ve left, in vital areas like security and crime.
Far better to say, from the outset, that the UK is happy to do no deal with the EU, with trade reverting to the World Trade Organisation rules that underpin international commerce the world over. That isn’t a bad option – at all. Such rules, which involve relatively low tariffs, broadly govern our trade with the US and China (our first and third- biggest export destinations respectively) and the rest of the 85pc of the world economy outside the EU. The non-EU accounts for 55pc of UK exports and rising, the EU 45pc and falling. We have a £60bn EU deficit, despite the single market, but a £30bn non-EU surplus, largely under WTO rules.
The UK should state clearly that WTO rules are fine. But if our European friends want to do industry-specific deals to lower related EU-UK tariffs, even better. Negotiating from WTO rules as our starting position keeps the big, politically explosive issues – borders, cash payments – away from the debate, so constructive relations can be maintained.
Given the EU’s huge surplus in key sectors where WTO tariffs are higher, like the car industry, the chance of securing a series of bespoke industry agreements is high. Trade in most financial services, meanwhile, would operate as now under “equivalence” rules.
Let the negotiations focus, above all, on such relatively technical issues. Not on borders and cash payments, the kind of matters that cause politicians to play to their domestic gallery, rousing nationalistic ire.
The Prime Minister was right to announce at Tory conference a “Great Repeal Act” – as suggested in last week’s column. Bringing relevant EU law onto our statute, then allowing us gradually to decide what to keep or retain, using normal parliamentary procedure, is the most democratic way to Brexit.
Negotiations starting with EEA membership, which then trying to unpick highly symbolic border and payment agreements with 27 EU nations, all with different opinions, will become an unseemly brawl. Not only UK-EU relations, but intra-EU relations, could be torn to shreds.
Declaring WTO rules satisfactory, alongside our Great Repeal, would minimise business uncertainty. It would also give us a decent chance of securing valuable sector-based agreements during the two-year Article 50 window. Hard Brexit would then become “Clean Brexit” – the fairest, least damaging, most adult solution.
In the here and now, though, sterling could become an issue. Further drastic falls in the pound could cause inflation to spike, while hitting investment from home and abroad.
A wholesale loss of faith in sterling, though, aside from Brexit squabbles, would again be driven by fundamentals. Chancellor Philip Hammond, in his conference speech, all but abandoned plans to “balance the books”. Both he and the Prime Minister are pushing far looser fiscal policy, “a new form of economic management”.
Just like our external deficit, the UK’s fiscal deficit remains dangerously high – around 5pc of GDP. While a shift away from quantitative easing has been mooted, more money-printing was announced in August – and that’s still to come. So sterling could certainly fall further. But Brexit, if well managed, needn’t be to blame.
Follow Liam on Twitter @liamhalligan