Weakness in the British pound could be warning that things are about to get a lot worse in the UK

The Bank of England has few options apart from extreme ‘sledgehammer’ stimulus that could drag on the pound with alarming consequences

PUBLISHED : Monday, 01 August, 2016, 11:55am
UPDATED : Monday, 01 August, 2016, 10:57pm

Crisis, what crisis? Just over a month after Britain’s landmark Brexit vote there is an uncanny sense of calm in the air. UK equity markets have regained some poise, the pound has stabilised after a fearful fall and overseas capital still seems to be flowing into the economy. The UK even managed a 0.6 per cent GDP rise in the second quarter. Some optimists are saying it is all a vote of confidence in Britain Plc. So what is all the fuss about?

On the positive side, the UK government has already made the break with former Chancellor George Osborne’s ‘balanced budget’ dogma

But the latest snapshots show clear-cut cracks starting to appear in the economy. Post-Brexit business confidence is showing sharp falls, consumer confidence is looking rattled and UK construction surveys are looking extremely weak. It is not surprising that forecasters are buzzing with speculation about a UK plunge into recession later this year.

We should know a lot more this Thursday, when the Bank of England gives its latest assessment of UK economic prospects and there is a very strong chance of a 0.25 per cent interest rate cut. The central bank has already made strong hints that the economy needs a summer stimulus after the Brexit shock. Chief Economist Andy Haldane even suggests the risks of a prolonged UK downturn are high enough to warrant overkill measures, using a sledgehammer approach to crack a nut.

But the UK economy needs less of a sledgehammer and more of a multi-tool piledriver to bolster the economy right now. The BOE’s likely response of negative interest rates, more QE and extra liquidity provisions over the future are bound to be a positive development, but they must be augmented by fiscal reflation and a much more proactive industrial strategy over the future.

On the positive side, the UK government has already made the break with former Chancellor George Osborne’s “balanced budget” dogma and seems inclined towards a more supportive fiscal stance in future. But, with Britain’s balance of payments falling deeper into the red, the government needs a quick re-think about closing the yawning current account deficit, currently running at 7 per cent of GDP. This is much bigger than the 4 per cent deficit at the time of the 1976 sterling crisis when the UK was forced to go cap in hand to the IMF for a sovereign bailout.

The weaker pound will help boost UK exports in the long run, but it is a risky strategy with very limited duration. The economy needs sustainable solutions for the longer term, which will return the UK’s external deficit back to the black. In the meantime, the UK could be sailing very close to the wind on another sterling crisis before too long, especially if international investors give the thumbs down to inward investment and growing impatience turns to outright capital flight.

Recent investor surveys make grim reading. Reuters’ monthly survey of UK-based funds conducted July 15-27 in the aftermath of the June 23 referendum shows some dramatic shifts in investor confidence. UK investors slashed their equity holdings in July to the lowest level in five years and halved the share of property holdings in their portfolios. London’s over-cooked property market, used by many overseas investors as a land bank, could be in for a deep shock.

With uncertainty on the rise, UK asset managers have bolted into safe haven investments, raising their allocations in UK government bonds to the highest level in almost five years. If international investors give a similar vote of no confidence to UK financial markets then the pound could be in deep trouble. In the absence of a credible post-Brexit action plan, laissez-faire, free market remedies will leave the UK economy perilously exposed.

In the absence of a credible post-Brexit action plan, laissez-faire, free market remedies will leave the UK economy perilously exposed

The plunge in the pound leaves strategic UK industries dangerously at risk of a yard sale. The government might think the recent sale of Britain’s leading chip maker ARM to Japan’s SoftBank is a positive step forward, but it leaves a huge hole in Britain’s domestic ability to compete in hi-tech global markets over the future. In the same vein, the proposed sell-off (or closure) of Britain’s vital steel industry should not be left to chance.

International investors will be watching the UK’s policy response very carefully in the coming months. If it is all left to the Bank of England’s monetary sledgehammer and more currency debasing, then the markets will have every right to mark the pound down.

Sterling is not out of the woods yet and is probably heading into deeper trouble before long.

David Brown is chief executive of New View Economics