Although the last leg in the pound's downward trajectory occurred suddenly and included a brief "flash crash" on Friday, the drivers of the decline have been long in the making, and the implications have yet to play out.
Here are seven things to know about the pound's present and future:
- After holding relatively steadily around $1.30 -- following an initial steep drop caused by the surprise outcome of the June 23 Brexit referendum -- the pound depreciated this week to around $1.24. The process has been volatile, including the 2-minute flash crash, which took the currency to $1.18 in Asian trading.
- The immediate cause of the depreciation was the indication by Prime Minister Theresa May on Oct 5 that her government would favor a "hard" exit from the European Union. This dashed hopes, including mine, that calmer heads would prevail and that the U.K. and its trading partners would pursue a softer departure that maintains much of the free trade and financial arrangements.
- The free-floating currency's depreciation was a logical response, given the addition of such structural uncertainty to the trading relations of the U.K., which was already running a current account deficit. After all, the U.K. has one of the more open economies, closely integrated with the rest of Europe on both the current and capital accounts of the balance of payments. Dismantling such long-standing links inevitably threatens trade and growth.
- There are hopes that the depreciation will soften the contractionary blow to the economy -- by encouraging exports, higher import-substitution production, larger tourist receipts and greater capital inflows. This is why the stock market is responding favorably -- when measured in local currency -- particularly the more outward-oriented index.
- Relying on exchange-rate depreciation is not without risk. Some of the desired economic responses may be stymied, or at least delayed, by the unusual uncertainty facing the structural future of the U.K. economy. There will also be price pass-through effects that threaten higher inflation and complicate the Bank of England's policy management. And if a hard Brexit pushes the economy into recession, U.K. policy makers will be faced with one of the hardest challenges: navigating stagflation.
- The political dimensions of the pound's depreciation are also worth monitoring. In the short term, they could include a renewed perception that financial developments are again favoring "international elites" at the expense of less fortunate segments of the population that have to deal with an inflationary threat. The positive responses of the stock market favor the better-off, who account for a disproportionate share of equity holdings. These developments are taking place even as the government is ramping up populist rhetoric in an effort to draw political support away from both the Labour Party and UKIP.
- The rest of Europe should not take much comfort from any of this. The pound's depreciation will be yet another headwind for economies that are already coping with economic and financial challenges.
There is one simple conclusion: If both the U.K. government and its EU partners insist on a hard Brexit, the pound could be in for further volatility and weakness; and the impact on the rest of Europe will not be favorable.
Mohamed El-Erian is the chief economic adviser at Allianz SE. To read more of his blogs, CLICK HERE NOW.
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