It's very easy to make a case to be short the Pound. The UK runs a Current Account deficit that has been primarily financed by European and Asian purchases of MBS which facilitated the housing boom. Now, however, the housing market is imploding, with many commentators forecasting a 35% peak-to-trough drop. The banking system is on its knees, with net bank lending contracting and mortgage approvals having fallen to historic lows. Moreover, Finance contributes a massive amount to GDP. Goverment capital injections and loan guarantees have failed to restart these markets as the banks concentrate on repairing their balance sheets, and worse still, the market fears that some (e.g. RBS) are "too big to be bailed out". Total external debt sits at multiples of GDP, making the country look like Iceland. Meanwhile, UK policymakers have panicked, with the Bank of England abandoning its moral hazard stance and dramatically slashing rates on its way to Quantitative Easing, while the Labour Government, acting on Gordon Brown's desperation to "win the election no matter what the cost", has unveiled ridiculous measures such as the 2.5% VAT cut. Such a borrow and spend mentality will saddle an entire generation with debt, and worse still, the international debt markets may decide to stop buying UK Gilts. Such an outcome would undoubtably result in another visit to the IMF, accompanied by a sharp devaluation, fiscal austerity and a dramtic fall in the standard of living (check out the 1976 application and behind-the-scenes events here (http://www.bankofengland.co.uk/publications/foi/disc060519.htm), recently released under the 30yr rule). Clearly the "correct" value for the Pound must be $1.00 and EUR 1.00?
Certainly, with such seemingly incompetent policymakers (though perhaps not as incompetent as those about to leave the US Treasury), the budget deficit set to balloon, and the banking system's external liabilities (relative to the size of the economy) being worse than any country save for Switzerland, the outlook for both the UK and its currency does not seem particularly promising. But it's not actually that difficult to make a case for buying the Pound. Actually, many of the above claims are, in fact, incorrect. A common occurance in financial markets is that a claim is made without recourse to the data and is mentioned so often that it becomes an accepted fact, shaping the outlook for prices and behaviour (George Soros's Reflexivity). For example, it is often asserted that the Financial sector contributes to about 25% to GDP and as a result, the UK is especially vulnerable to the ongoing crisis, but according the ONS National Accounts: Blue Book (http://www.statistics.gov.uk/downloads/theme_economy/BB08.pdf) the Gross Value Added by Financial Intermediation is in fact just SEVEN PERCENT, making it less important than Manufacturing (14%). Secondly, whilst UK banks' FX liabilities are extremely large, such statistics must be taken with a pinch of salt given the The City's role as one of the top international financial centres, which often serves to distort the data and provide inaccurate picture of the actual position (e.g. the 2005 reclassification of UK holdings of USTs to those held by foreign central banks and Middle Eastern investors).
Next, it's not actually obvious that UK Government debt is spiralling out of control, but the media (who love a good scare-mongering story) have repeatedly reported that it is. Much of this is an accounting question: how should the ONS account for the very large amount of contingent liabilities that the Treasury has taken on board as a result of the nationalisation of Northern Rock, the interbank loan guarantees and its explicit support for systemically important banks. Firstly, Northern Rock is also an asset that sits on the government's balance sheet to offset the liability that the ONS included in the official debt statistics (along with borrowing related to the Bank of England's Special Liquidity Scheme [SLS]), helping to send the level of public debt to 42.6% of GDP from 36% before the financial crisis hit (the most recent number, which includes other borrowing announced since the crisis started - e.g. for the fiscal stimulus and for the purchases of bank preferred equity - is 44.2%). But on the asset side of Northern Rock's balance sheet sit a great many mortgage loans, many of which will go bad. However, the vast majority will not. But if, for the sake of argument, we assume a blanket 35% loss on these assets (using the 35% peak-to-trough house price fall as a proxy), then the £55bn entry in the public sector debt accounts that covers this really is only a liability of about £19bn, lowering the effective public debt number from 44.2% to 41.7% of GDP.
Secondly, the borrowing embarked upon to fund the SLS is also not really a significant liability for the taxpayer because these Gilts are used as substitute for the Repo market for MBS (the BoE lends Gilts to the banks, taking MBS as collateral). Given that losses on this collateral will be taken by the banks (rather than the BoE) over time, and that systemically important banks are not being allowed to fail, it is not possible for a bank failure to trap these Gilts in the same manner as occured when Lehman Brothers International Europe entered Administration and leave the BoE with a capital loss on that collateral. Thus, subtracting this entry from the accounts, public sector debt falls to just 37.8% of GDP. As a comparison, when the UK was forced to seek an IMF bail-out in 1976, this measure stood at 54%. This also compares favourably with other countries: Germany (65.1%), France (66.1%), Italy (106%), Japan (195%) and the US (43%) - [note that the oft-cited public sector pension deficit issue is a global phenonemon, so the net effect of this issue, as far as currencies are concerned, can be discounted]. Admittedly, tax receipts will continue to fall as the recession deepens, weakening the fiscal balance, but this will also occur globally. Thus, the UK's fiscal situation, when compared with both previous debt problems in the 1970s and the rest of the world, is clearly not a catastrophe and there is significant room to borrow to provide much-need fiscal stimulae.
Thirdly, the UK Current Account has narrowed significantly, from a peak of over 4% to 2.1% of GDP. As the below chart illustrates, the UK C/A deficit is a symptom of the fact that the housing boom was primarily financed by European & Asian purchases of UK RMBS - the yellow line is the ratio of UK Halifax House Price Index to Average Earnings to give a measure of house price affordability. The white line is the yellow line scaled by EUR/GBP to give a measure of external house price affordability (i.e. how cheap is it for foreigners to buy UK housing assets), and the red line is the Current Account deficit as a %age of GDP. Much of this adjustment has been borne by an increase in domestic savings (net Mortgage Equity withdrawl has been negative for the past two quarters now) and a rapid and large fall in the exchange rate. Clearly this chart shows that UK housing affordability has now undergone a significant adjustment domestically (but has a way to go), however, *externally* it has fallen to the cheapest levels since the mid-1990s. Anyone who has been shopping on Oxford Street can testify that there are lots and lots of Europeans in most of the shops (especially the high-end stores) and crucially, they all seem to have shopping bags. The media reports of long queues on the motorway from Dublin to Belfast as Irish shoppers picked up bargins across the border are also well-known. A friend recently visiting a French supermarket remarked that even Champagne is now cheaper in UK supermarkets (where it is subject to heavy taxation) than in (untaxed) France. These factors have been affecting the UK Retail Sales data, which has consistently beaten analyst expectations as Europeans have taken advantage of how easy it is to travel here (thanks to Easyjet et al. and the Channel Tunnel) and arbitrage the 24% PPP-deviation.
Fourthly, according to the Bank of England, the UK's REER has fallen 30% since the crisis began in August 2007 - that is roughly the same adjustment bourne in 1931 when the Gold Standard was abandoned. The gain in competitiveness is very significant for the UK's eventual recovery - the external accounts are heading for balance and there has been little protestation from our trading partners. But the reaility is that the current level of the exchange rate is unsustainable for many European companies - I have heard of several medium-sized companies that are in such dire straits that they are being forced to pass on price rises of 6-9% purely to their UK customers as well as anecdotes of medium & high-end computing equipment prices jumping by similar amounts. I have also heard chatter that German & Japanese auto companies are seriously considering moving plant production to the UK.
Finally, the Bank of England prepared a report "UK export performance by industry" in its 2006Q3 Quarterly Bulletin (http://www.bankofengland.co.uk/publications/quarterlybulletin/qb060303.pdf} which attempts to quantify the response of exports to changes in relative export prices by export sector. Particularly interesting is that the sectors in which the UK can be described as "World Class" (i.e. those sectors in which it possesses a high share of world exports) appear to be those that respond extremely positively to an increase in price competitiveness. Specifically, Medical & Pharmaceuticals (15.3% export share, main competitors: US (16.1%), Switzerland (15.2%) and the Eurozone (33.4%)), Office Machinery & Computing equipment (11.8%, vs US (27%), Eurozone (18.5%), and Japan (22.8%)) and Communications (9.1%, vs US (17.6%), Eurozone (14.2%), and Japan (23.1%)). This study found that a 1% change in relative export prices raises exports by 2.2%, 0.5% and 1.9% respectively for these sectors. The first of these, is a non-discretionary sector and therefore is less vulnerable to the global slowdown, while the latter two are sectors that will play a part in the recovery as business fixed investment which (stagnated in the post-DotCom bubble world) is likely to an area invested in both by governments in fiscal spending and by corporates upgrading obselete equipment as the recovery gets underway.The above all imply that the UK is in a much better position than the consensus currently believes, and crucially, it has a source of future potential demand (via increases in the market share of industries that are either recession-proof or important to the eventual recovery). The fiscal position does not preclude the government from easing policy and the importance of financial intermediation and liabilities of the banking system are exaggerated. At such unprecedented levels of under-valuation, clearly changing fundamentals (as Europe faces its own recession) and a much stronger techincal picture (the MACD is signaling a "Sell" signal for EUR/GBP and it has broken down through the 23.6% Fibonacci retracement of the move up from October to December) maybe it's time to buy some Sterling?
P.S. - Happy New Year!
