The British pound (GBP) is a hard currency with the exchange rate experiencing strong appreciation over the last 7 years against the US-dollar (USD) although currently hitting all time low exchange valuations to the Euroland euro (EUR). Is there a sea change in the works for the GBP – USD pair? And what about the future of currency use for the United Kingdom and its 60.77 million citizens, will the EUR replace the GBP in the near term as new national currency?
Below is a summary of our research notes for the British pound as presented by BankINTRO.com.
POLITICS: Prime Minister Gordon Brown – Labour is the governing party. For further details, please contact BankINTRO.com.
ECONOMY: the UK is a major world economic power representing the world’s sixth largest economy, member G7. Britain is a diverse economy home to a wide array of industries including machinery to consumer goods. Similar to the United States, Britain has enjoyed tremendous appreciation in property prices coupled with a vast increase in household debt. As a member of the European Union since 1973, the UK is a mature industrialized advanced nation moving towards a knowledge based economy similar to that of the United States, a prudent decision on the future of their national currency will only help to foster this hi-tech service economy.
From year 2001, the relatively higher world oil price has given the pound a further boost of appreciation from oil production from the North Sea oil fields off the coast of Scotland. Overall, the UK economy has performed very well over the last few years with steady real GDP growth and lower unemployment levels at 5.4 percent (2007). However, the second phase of the global recession ‘asset liquidation’ that is starting to take affect within in the United States economy may now spillover into the United Kingdom as GDP growth is expected to slow in the second half of 2008. The British manufacturing sector are showing signs of cooling and lower business investment, the British consumer sector is swamped in household debt and may just started to stall, unemployment is starting to rise from its historic lows. The trade deficit for the UK is worrisome as it is expanding to record levels; the fiscal deficit is at the limit of European acceptance.
Although structural economic deficiencies are evident with the UK economy, great strides are being made in advancement in areas of the Internet / Knowledge economy. A major backbone to the economy remains the UK’s large North Sea oil & gas project which is at maturity; however, the oil fields are now in decline. This is negative for the GBP; the UK is now on a path of being a net importer of oil. Britain’s banking, insurance and business services represents the largest share of domestic GDP at 75.5 percent while the industry component is declining at 23.6 percent. The service sector is showing strong signs of a slowdown. A serious risk to the UK economy and sterling is the growing persistent current account deficit which came in at 4.2 percent of GDP (2007).
A looming difficulty for Britain on the horizon is the turn of events in the fiscal account from surpluses to now projected deficits. During year 2001-02, the budget was in surplus at 1.7 percent of GDP and year 2000-01 at a huge surplus of 53 billion USD due to a one time sale of mobile phone licenses. The fiscal deficit for 2003-04 was recorded at 3.5 percent of GDP which breaches EU fiscal guidelines of 3 percent deficit shortfall whilst year 2005-07 have had large shortfalls nearing 3 percent. The problem is political. During the good times over the last few years, the UK ran deficits. A healthy economy should run surpluses during an economic boom and then run deficits during the recession to stimulate GDP growth. The UK took its cake and ate it too; they did not save during the good times. Will there be more economic pain ahead, a deeper recession than what should be garnered due to political incompetence? Will tighter credit conditions prevail hence further impacting demand?
Is the UK economy going into recession on a similar path as the United States economy? Large increases in UK government spending will most likely overshoot spending targets, a household sector swamped in debt with the threat of rising long term interest rates, falling UK home prices, higher taxes and higher food prices. BankINTRO.com forecasts tougher times ahead over the medium term for both Britain and the United States. Of interest, there has been debate for the rich non-domicile foreigners who maybe hit with an annual tax of at least 30,000 GBP, some of these rich foreigners make take there money elsewhere.
UK HOUSING MARKET - A Bubble Ready to Burst?
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Total GDP is in excess of 2.15 trillion USD (2007) as measured by purchasing power parity with corresponding GDP/Capita at 35,300 USD. GDP as measured by market prices at 2.75 trillion USD (2007). GDP growth for 2007 at 3 percent, GDP growth for year 2008 is forecasted at 1.7 percent. Inflation for year 2007 came in at 2.4 percent, year 2008 at 2 percent. Money supply growth was measured at 12 percent (2007). Current account deficit shortfall for 2007 came in at 4.2 percent of GDP, QTR 4 2006 at 3.8 percent. Trade deficit for year 2007 is large at 180 billion USD. Public sector net debt to GDP is at 38.3 percent of GDP (2007). External debt is large at 10.45 trillion USD equivalents (2007). Fiscal deficit is close to 3 percent of GDP. Energy self sufficient - oil production for 2005 at 1.86 million b/p/d, proven oil reserves are at 4 billion bbl (2006). UK natural gas reserves measured at 509 billion cu m (2006). Poverty line is at 14 percent of the population (year 2006).
POSITIVE: although manufacturing is in decline, the economy is re-allocating capital towards knowledge, business services & hi-tech industries including biotechnology; very efficient agricultural production. CONCERN: terror strikes - London, need for improvement in capital formation (venture capital markets), development of skill levels, upwards of 14 percent of the population are living in poverty, business investment is slowing, off sheet balance liabilities, sky high consumer debts and excessive money supply growth.
BANKING SYSTEM: the UK is well known for its sound centralized banking system and modern financial markets. London is considered to be a premiere financial centre in the world today. The Bank of England became free with independence from government in 1997. Over the last few years, the Bank of England has aggressively reduced gold reserves. If euro adoption as new national currency takes hold, then the Bank of England will correspondingly become irrelevant as monetary policy will be conducted from the European Central Bank (ECB). At present, the Bank of England holds a 2 percent inflation target plus/minus 1 percent band with current UK interest rates holding at 5.25 percent as set by the MPC (Monetary Policy Committee - Bank of England). As of February 2008, UK gross reserve assets were measured at equivalent 45.2 billion USD. years 2005-06, there was strong central bank buying of GBP. The Northern Rock mortgage lender bailout (fall 2007) costs the British taxpayer negatively on sterling exchange valuation.
REGIONAL ANALYSIS: Denmark, Sweden, Eurozone
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KNOWLEDGE: The EURO (EUR) Decision
Euroland euro question is politically driven particularly since the EUR is a relatively a new currency with some of its own problems such as the EU’s stability & growth pact guidelines which are at times breached by various EU countries. Some analysts feel the euro is based upon unrealistic economic variables which may derail economic and monetary union (EMU) entry for the United Kingdom. Politically, the UK Conservatives are against adopting the euro while the current Labour government in power supports euro membership. Arguments for euro membership for the UK include from increased trade, higher growth and ultimately a larger wealth pie from increased national GDP thus resulting in a higher standard of living. Will the Labour party be on its way out in the next election as the British electorate favors a sea change in governing? Quite possibly. Is the UK’s relatively strong economy over the last couple of years sustainable? Unlikely as the UK economy has been fueled by debt both from government fiscal deficits and a credit boom via the household sector enjoying a debt spending spree triggered by low interest rates and aggressive lending.
Britain’s advantage to join EU’s single currency zone as this will further promote investment in the UK. The view is also widely held that the UK will have less influence should it remain outside the Eurozone thus potentially creating greater harm to the UK economy over the long term. However, some thinkers and members of the Conservative party believe the UK maybe better off joining the North American Free Trade Agreement “NAFTA” and aligning itself closer to the United States, Canada and Mexico.
Ironically, the euro is well on its way to becoming indirectly a parallel currency within the UK. Britain may indeed join the euro through ‘membership by osmosis’ as many more UK businesses accept the euro for transactions, also known as ‘Eurocreep’ as numerous UK retailers accept euros.
opinion polls within the UK show a majority of Britons are against joining EMU by adopting the euro as new national currency. A stronger UK economy will make it a tougher sell for joining. At the time of euro decision, a stronger Eurozone economy will make it an easier sell to the British people for euro membership. However, it should be noted that with expected EU enlargement to take place over the next few years, as new countries join EMU, the Eurozone market becomes that much larger and lucrative.
UK government will lose political clout and hurt economically if Britain does decide not join the euro. The Conservative opposition who wish to keep pound sterling as national currency says that joining the EUR will weaken Britain’s economy coupled with the loss of sovereignty as interest rates will be set by the European Central Bank ‘ECB’. Some analysts have talked about the high price by the UK to keep the pound. Conversely, the potential to increase trade if the UK adopts the euro may result in an increase of British standard of living by upwards of 20 percent over 25 years coupled with a British GDP growth rate that will be upwards of 1 percent higher per year. Many UK businesses would then obtain greater access to Eurozone markets while benefiting with increased foreign direct investment ‘FDI’ with increased trade between the UK and the Eurozone. With the current status quo, Britain has had a history of boom and busts with its economy. The Eurozone is the UK’s largest export market of which Britain is presently running a trade deficit with the Eurozone. The Eurozone represents close to 60 percent of the UK’s exports while America accounts for 35 percent.
‘Five Economic Tests’ for adopting the EUR were set out in 1997 by the UK government; Britain must achieve them before euro currency transition can take place. The government states that it is in favor of euro membership when the economic conditions are right. As of spring 2003, the UK has failed 4 out of 5 tests for euro adoption. These five economic tests include: Convergence - single interest rate, Flexibility - way to solve problems, Investment - better conditions over the long term, The City - London for financial services and Stability/Growth/Jobs.
BankINTRO.com predicts a Conservative election victory sometime in years 2009-10; hence, the euro is unlikely before 2015 at the absolute earliest after a 2 year ERMII period assuming a Labour victory sometime around year 2013. So perhaps the EUR by year 2020? UK is currently not on ERMII, a precursor for joining euro common currency. The UK joined ERM1 back in the early 1990’s but was forced off as they joined at incorrect exchange rate at that time. There will be required a strong political will to push EUR proposal forward, likely when UK needs the Eurozone for increased economic needs. Euro adoption is likely at a particular time when the UK economy is much weaker than Eurozone, then the push in attempt to raise British living standards.Current PM Brown states the UK will join when the time is right for Britain.
CURRENCY: ISO symbol ‘GBP’, pound sterling, British pound. At time of review on April 4, 2008, pound sterling had an exchange valuation of 1.993 US-dollar (USD) to 1 GBP and/or 1.27 Euroland euros (EUR) to 1 GBP. Floating currency exchange rate regime is in place although currency controls were in place from the late 1960’s until 1979. ONovember 7, 2007 the pound traded at recent high level to the USD at 2.116 USD to 1 GBP since 1992 just before the pound crashed out of the European exchange rate mechanism. Conversely, on March 31, 2008 the pound traded at a historical low valuation to the Euroland euro at 1.2563 EUR to 1 GBP. At present, the GBP is the third largest global reserve currency behind the USD, EUR. As measured by purchasing power parity, sterling is 30 percent overvalued to the USD as of March 31, 2008 and is undervalued by 5 percent to the euro.
CURRENCY HISTORY: the pound sterling is the currently the longest government issued currency in circulation today since around year 775.
Sterling currency crisis occurred in September 1992 when the traders won and the politicians lost as the pound was devalued as membership to the European Exchange Rate Mechanism (ERM) was discontinued after only 2 years. The British pound for decades has had a history of significant swings in valuation. In the 1970’s, sterling hit a high of 2.62 USD range to 1 GBP at which time the U.S. economy was becoming unglued with high inflation and recession. Conversely, by the late 1990s when the U.S. economy was at the height of its economic boom, sterling hit a low of 1.10 USD to 1 GBP. Sterling’s last 20 year exchange valuation average is approximately 1.70 USD to 1 GBP.
Historical exchange quotes for pound sterling are as follows (USD/GBP): year 1940 at 4.03 USD to 1 GBP pegged rate until September 1949 when devalued to 2.80 USD. In 1967, GBP devalued again to 2.40 USD. Other quotes include: January 1971 at 2.405 USD to 1 GBP, March 1972 at 2.617, June 1973 at 2.576, January 1975 at 2.362, October 1976 at 1.617, January 1978 at 1.849, August 1979 at 2.236, January 1981 at 2.402, January 1982 at 1.885, March 1983 at 1.489, February 1985 at 1.05 (low), May 1986 at 1.5208, April 1988 at 1.878, April 1990 at 1.637, August 1992 at 1.943, November 1992 at 1.526, August 1994 at 1.542, March 1996 at 1.527, January 1998 at 1.635, January 2000 at 1.64, June 2001 at 1.402, June 2003 at 1.66, January 2004 at 1.823, January 2005 at 1.877, February 2006 at 1.747, January 2007 at 1.958, November 2007 at 2.11607 (high valuation for GBP), March 2008 at 2.
Historical quotes to the Euroland euro (EUR/GBP) include: January 1999 at 1.423 EUR to 1 GBP, January 2000 at 1.62, January 2001 at 1.577, January 2002 at 1.623, January 2003 at 1.522, January 2004 at 1.445, January 2005 at 1.434, January 2006 at 1.459, January 2007 at 1.508, August 2007 at 1.477, March 2008 at 1.289 (low valuation for GBP).
CURRENCY FORECAST: BankINTRO.com thinks that sterling will begin to depreciate modestly to the USD as the UK credit bubble implodes and we expect the USD will begin a cyclical rebound in valuation in late 2008. Our best guess exchange valuation for sterling is 1.88 to 1.92 USD to the GBP by year-end 2008 and further depreciates back towards the 20-year average valuation of 1.70 USD to 1 GBP by year-end 2009. An exchange valuation towards 1.60 USD range is more indicative of purchasing power parity for pound sterling.
Looking at interest rate differentials, the Eurozone interest rate is at 4 percent, US Federal Funds rate is at 2.25 percent (March 2008), the UK at 5.25 percent. Eurozone inflation is running at 3.5 percent (March 2008) thus suggesting lower ECB rates are unlikely for Eurozone in short term. Within the United States, inflation is running higher as well at 4.1 percent; UK inflation is running at 2.5 percent. Interest rate differentials suggest mildly bearish support for sterling as UK rates are expected to decline modestly possibly to 4.75 percent by year-end 2008. It is expected that the United States will begin to raise interest rates in late 2008-09 (long term US rates may move sooner with the higher US inflation figures) thus narrowing UK – US rate spread, this is bearish for pound sterling in relation to the USD.
Capital movements within regions and countries will ultimately determine exchange rate value, supply and demand. our view, the UK may experience higher threat of capital flight with higher taxes thus resulting in a gradual GBP depreciation versus the USD. Further, it is quite likely that a UK banking credit crisis is on the way in similar fashion to what is taking place within the United States. The failure of British mortgage lender Northern Rock in September 2007 is the canary in the coal mine. A housing correction in the magnitude of 30 percent for the United Kingdom is feasible.
The key future decision for Britain is to solve their current identity crisis. The future of the UK and their currency, ‘pound sterling’ has three choices to make: stay with the GBP, join the euro or align itself closer to the United States. BankINTRO.com believes that the United Kingdom will not make a decision with respect to possible euro adoption before year 2015 at the earliest. concept of accepting a common currency such as the euro is currently not at the top of the list politically or by the British public. However, if the UK enters a deep recession or experiences a dramatic decline in living standards compared to those in the Eurozone, then the debate for accepting the euro as their new national currency will indeed heat up. adoption in our opinion would be the smart decision as trade and access to large markets is vital for the well being of any economy.
With the European community representing over 60 percent of UK’s exports and increased competition from competing financial centers, Britain will be able to position itself strategically by accepting the euro as new national currency. As the world moves into regional trading blocs, remaining solely with sterling is not a viable option over the long term nor is dollarizing the UK economy with the USD - this is not an acceptable choice either. Ironically, the UK has very similar economic features like America as both nations have large current account deficits and bulging fiscal deficits. Expect the GBP to play catch up and begin to depreciate against the already beaten up USD.
UPDATED: April 4, 2008