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Issue 2/28 January 2009

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Today’s Issue Includes:


1) What are the implications of the fall in Sterling? By Nigel Tree

Recession image“I would urge you to sell any sterling you might have. It’s finished.” So said Jim Rogers, of Rogers Holdings based in Singapore and the co-founder with George Soros of the Quantum fund just a few days ago. In this article I will look at how fast sterling has been falling and how this is having an impact on the UK economy.

The fall in sterling hit home to me last week in the place where it really makes an impact – my pocket! My daughter is just starting her third year at the University of Kwa Zulu Natal in South Africa (she went for a gap year to work in an Aids orphanage and stayed) and it was time to pay the fees again. Unfortunately for me, the fees are set in US dollars, 6000 of them to be precise. Last year I only had to give 51p for every dollar I purchased. Two weeks ago it cost me 72p per dollar. This meant a rise from £3000 to £4300 or an increase of about 43%. And this at a time when prices are supposed to be falling!

Before you start sending me directions to the nearest soup kitchen, this fall in sterling is having a major impact on the UK economy. You can see the decline over the past year in the figure below.

Early signs of the J-curve effect?

Following the depreciation of a currency we would expect the current account to worsen initially. This is because whilst prices will have gone up for imported goods many companies will be tied in to pre-existing contracts and will have to carry the increased cost. Britain’s trade deficit did actually widen in November 2008 to £8.3bn from £7.6bn in October which is evidence of this effect. In fact this monthly deficit was the worst since records began in 1697.

But where is the boom in exports?

In the three months to November 2008 our total exports, excluding oil, actually fell by 5.2%, whilst imports only fell by 0.7%. It would appear that the sharp fall in sterling has not been sufficient to offset the collapse in world demand which has resulted from the credit crisis. Some commentators have also pointed out that many of our manufacturers will not have been able to take advantage of their greater price competitiveness due to the fall in sterling, because of the difficulty in borrowing money to fund increased production.

Some UK firms starting to be hit by the fall in sterling

With sterling having fallen by 8% against the dollar and 5% against the euro in the last week alone and currently at a 24 year low, the implications for UK companies is serious. Two days ago British Airways warned of an expected loss of about £150m for the current financial year. This was mainly due to increased cost of aircraft leasing which is paid in dollars. And yesterday, Wolseley, the British plumbing and heating supplies group, announced that it had been hit to the tune of £557m by adverse currency movements.

Will there be more signs of protectionism and competitive devaluations?

You just have to see the influx of cars bearing Irish number plates streaming over the border into Northern Ireland to purchase goods which have suddenly become substantially cheaper, to see the effect on the eurozone. Many shops in Northern Ireland are actually taking payments in euros.

A major concern is that countries will try to force their currency downwards to gain a competitive advantage. World trade flows are already falling swiftly and the question is will there be a return to the beggar-my-neighbour policies of the 1930s when international trade didn’t just shrink but virtually collapsed.

Already, the Obama administration has accused the Chinese of manipulating their currency to depress its value and thus increase exports. A US spokesman said that Mr Obama would “use aggressively all the diplomatic avenues open to him to seek change in China’s currency practices.”

The eurozone and Japan have been particulary hard-hit by their appreciating currencies and we will have to wait and see how countries are going to react.

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2) Monetary policy and the danger of deflation. Interview with Dr George Buckley, Chief UK Economist, Deutsche Bank.

2. Monetary policy and the danger of deflation. Interview with Dr George Buckley, Chief UK Economist, Deutsche Bank.

Nigel Tree asks the questions.

NT: You predicted the reduction in base rates by 0.5 percentage points on 8th January and you are quoted as saying that you see rates being cut by another half-point in February and again in March, which will see rates fall to 0.5%. What do you see as the implications of such a reduction on the economy and sterling.

GB: According to the Bank of England's own economic models, it generally takes just over a year before changes in interest rates have their maximum impact on economic growth. So rate cuts now may take some time to have a positive effect. In addition, with official interest rates having never reached such low levels as they are at today (the previous record low, since the Bank was founded in 1694, was 2%) it is very difficult to judge what effect lower rates might have in this environment. Any influence of lower rates on the economy might not be linear - a rate cut of, say, half a percent may prompt a different (probably smaller) economic reaction if enacted when the level of rates is 1.5% rather than 5%.

As for the impact on sterling, the foreign exchange market is probably already "pricing in" (i.e. expecting) further interest rate cuts, as well as quantitative monetary easing (see below). So there might be a bigger reaction of sterling to no change in interest rates than to an expected rate cut. Currencies react, therefore, to unanticipated changes in interest rate differentials, but the way in which they move is not always easy to determine. On the one hand, were the Bank of England to cut interest rates (relative to those in the US or the euro area) more sharply than expected, then sterling might depreciate as lower returns encourage investors to sell pounds in favour of holding dollars. Alternatively, lower interest rates now might over-stimulate the economy (wishful thinking!) and cause much higher rates eventually - in which case the demand for sterling (and, therefore, its rate against other currencies) might rise in anticipation of future higher rates.

NT: Keynes described the asymmetry of monetary policy as like “pushing on a piece of string.” How can monetary policy function when interest rates are close to zero and what is “quantitative easing” and where does it fit in?

GB: It is not quite true that market interest rates cannot go below zero. There have been some isolated cases (such as in the US recently) where very short term interest rates (for overnight borrowing) have dipped modestly negative, as investors become willing to pay banks to keep their money safely in a rather unsafe environment. But such an event is unusual, and the lower limit to central bank interest rates is zero. As risk-free (central bank) interest rates approach this lower bound, some other borrowing rates in the economy might no longer continue to fall. Not all borrowers are risk-free, and therefore there may be a level below which banks are not willing to lend out money to such individuals or firms. So while official interest rates keep falling, these cuts are not being passed on as much as they were when the level of interest rates was higher.

As a result, when conventional monetary policy measures become less effective or interest rates reach zero, the Bank of England and the government need to switch to unconventional measures. One of these is what's known as "quantitative easing" – this is what Japan did from 2001 to 2006 in its attempt to combat weak economic growth and deflation. This is when the central bank buys assets such as bonds - which it funds not by increasing government debt, but rather by simply expanding the money supply. The effect of this policy could be to take some of the so called "toxic assets" off commercial banks books and help reduce interest rates in the market - both of which should encourage banks to lend money again. There is a risk involved in printing money, however - it may eventually lead to significant inflation. As Milton Friedman once said, "inflation is always and everywhere a monetary phenomenon".

NT: Is the UK in danger of suffering from deflation as happened in Japan in recent times?

GB: Quantitative monetary easing might help us escape small price falls becoming fully fledged (Japan-like) deflation in the future. Back in the 1930s, economist Irving Fisher described the processes which cause sharp economic slowdowns. He said that there were lots of reasons we might drift into recessions, but two of those reasons in particular stand out as causes of depressions. Those are i) starting the cycle with lots of debt and ii) deflation. How does this work? With high debt levels, an economic shock (such as the credit crunch) can lead to people and businesses liquidating assets and reducing their debt. But that in turn leads to a weaker economy and lower general prices. With inflation negative, the real value of the debt rises - requiring people to liquidate their debt even more... and so the cycle continues, causing prolonged depression.

The most recent occurrence of prolonged deflation in a developed economy occurred in Japan from the late 1990s. However, there are some specific reasons that Japan suffered so much and why the same might not happen in Europe and the US today. Japan failed to provide capital to its beleagured banks quick enough when the crisis hit, interest rates did not fall fast enough, and the government did not provide a large enough fiscal stimulus. This time round, governments have gone out of their way to do all three. There is no guarantee that this will work, of course, but there is a lot of stimulus out there at the moment and one would hope that it eventually has some powerful effect.

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