Sterling and Brexit

May 16, 2016

A referendum to decide whether Great Britain remains in the European Union is scheduled for June 23, just over five weeks away.  Economic experts and other pundits both within the U.K. and in the wider world community widely predict that a verdict to leave the EU would be disastrous both in the immediate term and over the longer run for the U.K. economy and that it has ominous implications for wider Europe and all western nations.  The EU’s forerunner, the European Common Market was formed in 1957, but Britain didn’t join until the start of 1973.  The group’s name changed to the European Economic Community (EEC) and eventually the European Union (EU).  The basic goal of the union was to establish a code of harmonized policies allowing for freer movement of people, goods, services and capital for the members’ mutual benefit.  Two and a half years after the U.K. joined, British voters approved membership in the EEC by a margin of two to one in a referendum that produced a turnout of 64.5%.  In spite of the sentiment among economic and political experts this time around and the result of the earlier 1975 referendum, markets are very uneasy, because opinion polls show only a small voter majority favoring staying.  Britain’s image has suffered already, and the Bank of England last week revised down projected growth in 2016 and 2017, regardless of the referendum’s outcome.  But make no mistake, the greater longer term turmoil by far will result if the Brexit forces win out.

It seems appropriate to give a quick rundown of sterling’s history, since any idea regarding how far and quickly it might depreciate on a vote to leave the EU needs to be set against the framework of where the currency has traveled.  First, some brief comments about the time prior to the era of floating exchange rates.

  • In 1939 when the U.K. entered World War II, the pound averaged $4.86.
  • It declined to a mean of $4.03 the following year, and after the war was devalued in September 1949 to $2.80.
  • A second devaluation occurred on November 18, 1967, to $2.40.
  • Floating dollar exchange rates began in March 1973, and sterling averaged $2.4510 that year.
  • Eleven months before that new era began, the founding six members of the EEC launched a joint currency float known as the EC snake that permitted 2.25% margins up and down against one another within the broader 4.5% bands of movement vis-a-vis the dollar.
  • Along with Denmark, the U.K. joined the snake on May 1, 1972, but speculative pressure impelled it to withdraw six weeks later on June 23, ironically exactly 44 years to the day before the upcoming Brexit referendum.

Sterling averaged $2.3952 against the dollar in 1973-74, very close to its parity after the 1967 sterling devaluation, but weakness emerged and intensified during 1975 as reflected in its quarterly averages of $2.3920 in the first quarter followed by $2.3246 in 2Q, $2.1284 in 3Q and $2.0423 in the year’s final quarter.  1975 proved to be but a prelude to the bloodbath of 1976.  Press reports as far back as April 1975 had suggested that the British Government favored sterling depreciation, and when the Bank of England was seen intervening to sell the pound in March 1976, presumably to engineer a controlled transition through the psychological $2 level, a speculative frenzy instead ensued.  Sterling was in free fall.  In June, the Group of 10 nations agreed to a $5.3 billion support package for the British currency, but still it fell.  Bottom wasn’t hit until October at $1.5550 and solidified later when the U.K. submitted a Letter of Intent to the IMF that December.

The anticipation of North Sea oil production and the dollar’s own woes in the first couple of years of President Carter’s stewardship helped sterling recover, and it averaged $1.9625 in the five years through 1979.  That year saw Margaret Thatcher’s Conservatives take power in Britain, and the pound averaged $2.1218 followed by $2.3253 in 1980.  But the five years 1980-84 was a period of extraordinary dollar strength, and the pound averaged $1.7908 over that term.  Despite a general dollar downturn, sterling was even weaker on average at $1.5645, in the next five years of 1985-89.

Way back in 1979, a number of Continental European government had launched another joint currency float known as the Exchange Rate Mechanism (ERM), which would go on to play an important role in determining how countries were to become eligible to adopt the euro as their money.  Debate in Britain by the late 1980s became bitter over whether sterling should join the ERM, and the handling of this divisive matter became a main issue over which Thatcher was dumped by her own party.  On October 8, 1990, sterling joined the ERM with a central parity against the German mark of 2.95.  History repeated, and the pound withdrew on September 16, 1992 just as it had from the snake in 1972.

Abandoning the ERM was a huge political humiliation but an economic bonanza, as sky-high British interest rates needed to defend the pound’s parities when in the ERM were then lowered sharply.  And ironically, the pound after leaving the ERM secured greater stability against the dollar, averaging $1.6700 in 1990-94, $1.6099 in 1995-99, and $1.5854 in 2000-04.  In the meantime, the Bank of England became truly independent in 1997.  When Tony Blair’s Labour party returned to power in May, one of the first actions was to shift monetary policy making authority from the Treasury to the central bank.  In 1999, when the euro was launched, Britain opted out of the arrangement and kept its own currency and control over its short-term interest rates.  Warnings at the time that the U.K. economy would go downhill because of that decision did not transpire largely because the more important linkage, membership in the European Union, continued.

Whether Britain now also abandon’s the EU is now up for a vote.  In the time since the euro was launched, the pound has averaged $1.6486 against the U.S. currency, 14.5% above today’s close of $1.4392.  The euro’s mean against the pound has been 0.7389 since the start of 1999, comparatively closer to its current level of 0.7864.  Sterling’s strongest levels in the post-euro era were at $2.1160 on November 9, 2007 and EUR 0.5688 on May 3, 2000.  It’s weakest points were at $1.3505 on January 23, 2009 and EUR 0.9803 on December 30, 2008.

Not since 1976 has sterling weakness been the primary currency market motif.  Stay tuned…

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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