The pound is plumbing near-historical depths. Why?

KWASI KWARTENG, Britain’s new chancellor of the exchequer (pictured), insists he is not one to be moved by the gyrations of currency exchanges. “The markets will react as they will,” he told the House of Commons on September 23rd after unveiling Britain’s largest raft of tax cuts in half a century, largely paid for by borrowing.

His recklessness has been put to the test. On September 26th the British pound slumped against the dollar as markets opened in Asia, plunging briefly below $1.04. The drop came on the back of a wounding sell-off on Friday, after Mr Kwarteng’s announcement. In Asian trading hours the pound settled at around $1.07, down around 1%, as interest rate expectations climbed. The currency’s historical low, measured by the price at 4pm in London, was reached on 26th February 1985, at $1.042.

This year, as in 1985, much of the pound’s drop actually reflects the strength of the dollar. Sterling is down by about 20% against the greenback in 2022, not much more than the euro’s 15% and in line with the Japanese yen’s decline. But in the past week sterling has slumped against most currencies, not just America’s. That decline has been accompanied by rising government-bond yields, something that would usually encourage international investors to buy sterling-denominated assets on the expectation of stronger returns. Five-year British yields have risen from 1.5% at the beginning of August to above 4.5% now: an increase of about one percentage point in just two days.

That combination of rising yields and a falling currency has prompted discussions of a broader crisis of confidence in Britain’s economy and its assets. The government’s tax cuts will mean a growing budget deficit and higher public-debt levels in the future. Britain’s current-account deficit reached 8.3% of GDP in the first three months of the year, the deepest in modern history, driven by surging energy prices. A gaping current-account deficit is something that often worries those who invest in developing economies.

But in other ways Britain is an unusual candidate for a currency crisis. Its exchange rate is flexible, meaning that there is no link to another currency, as was the case when Britain was forced out of the European Exchange Rate Mechanism in 1992. Its financial markets are deep and sophisticated. It has minimal debt denominated in foreign currencies, and its central bank is independent from the government.

The most simple explanation for the sell-off, then, is that investors do not believe that the government’s tax cuts will lead to the real economic growth Mr Kwarteng wants. Instead, they foresee higher inflation that the Bank of England will be unwilling to fully offset with interest-rate increases. Currency analysts at the Bank of America suggest that a combination of Britain’s changing fiscal stance and the long-running effects of its decision to leave the European Union have led to a profound rethink of the pound by investors. That leaves the currency more vulnerable in the years ahead.

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