Before Andrew Bailey, the governor of the Bank of England, spoke to this paper’s economics editor, the pound was the best-performing currency among Group of Ten (G10) wealthy nations. It was just a fraction away from reaching its level on the day of the 2016 Brexit referendum. While financial capital flows primarily determine the pound’s value, Mr Bailey’s suggestion that the Bank might be “a bit more aggressive” in cutting interest rates caused the pound to drop sharply.
Those four words have changed the narrative that UK rates would stay put because inflation had not been defeated. Traders thought it would be better to hold pounds than other G10 currencies. Before Mr Bailey’s interview, the Wall Street Journal noted: “Markets suggest that borrowing costs in the UK will be set at 4.3% six months from now. In the US, they are expected to be below 3.5%.”
Aside from government intervention, there are three primary reasons to buy foreign currency: to import goods and services, make direct foreign investments, or engage in portfolio investment. Among these, imports are the least significant. This wasn’t always the case. It is said that Labour’s Harold Wilson blamed media coverage of Britain’s ballooning trade deficit for his unexpected election loss in 1970. There had been good reasons for voters’ concerns. Their confidence had been shaken by Britain’s deteriorating balance of payments and a string of recurring currency crises that led to a 1967 devaluation. By 1970 it was among their top three concerns.
Today Britain runs a trade deficit while its currency has strengthened. Balance of trade figures rarely make news. That is not to say they are unimportant – and along with interest rates, unemployment and inflation, these indicators often determine short-term currency prices disproportionately because whatever traders think is true becomes fact as it then moves the market. In the long term, as economist John T Harvey explains in Currencies, Capital Flows and Crises, it is financial capital flows, not international trade, that drive currency movements today. The volume of pounds traded in foreign exchange markets, as reported by the Bank for International Settlements last year, exceeds the total value of UK imports and exports by more than 100 times.
The strength of sterling is related to Britain’s political economy. The new government aims to drive “inclusive” growth through both financial services and manufacturing. However, financial services rely on attracting substantial capital flows – boosting employment in London and increasing tax revenues. The downside of this approach is that it could strengthen the pound and expand the trade deficit, further diminishing the UK’s share of global manufacturing, ultimately leading to lower employment and reduced tax revenues.
Given that the UK has dropped out of the top 10 manufacturing nations for the first time, Labour must balance the demands of a thriving financial sector with the need to revitalise its weakened industrial base. Will ministers prioritise state intervention to enhance the competitiveness of strategic industries, downplaying the pound’s strength in the knowledge its value is secured by large portfolio flows? Or will they capitalise on a strong pound to attract long-term investment into the real economy via financial services? The answer may only become clear when the government’s industrial strategy outlines how far private capital will be required to commit to transformational priorities, even in the face of adverse market signals or failures.