Open Europe Blog

Ahead of David Cameron’s incredibly hyped speech, a bit of a foreign exchange side-debate has developed with some analysts suggesting that sterling could weaken significantly as talk of the UK leaving the EU increases uncertainty, while the eurozone starts to recover. Are such fears valid?

 

·         As we have pointed out repeatedly in recent days, the debate is not yet about a straight in or out– but whether the UK should seek new EU membership terms.Unfortunately, currency markets (notoriously volatile) may not capture that, even if businesses do.
·         In our view, if you’re a currency analyst, there are more important issues that could drive sterling lower than the intensified EU debate, including the threat of a triple-dip recession, loss of the UK’s triple-A rating, continuing to miss debt and deficit targets and the election campaign in 2014/2015. Ultimately, we’d expect currency markets to take the lead from the UK’s wider economic policy than just the UK-EU issue.
·         As we discussed in detail in our outlook for2013, there is still a lot of uncertainty in the eurozone, particularly with the Italian elections and the fact that the structural flaws have not been solved. The ECB is also still providing copies amounts of liquidity with a very loose monetary policy. Although, the latter has helped strengthen the euro at times, we think there is a limit to how far this can go. During the crisis, the repatriation of assets from abroad by banks and firms in the eurozone has propped up the currency, as the situation improves slightly this may slow. These factors combined could cap any substantial strengthening of the euro.  
·         Although sterling has weakened in recent days, other indicators of safe haven flows, such as UK borrowing costs and the London property market, have continued to suggest that there is still very strong demand for UK assets.
·         Given that safe haven flows have continued for some time, sterling may be inflated above where it normally would have settled, as such any change may simply be a correction to the norm as markets turn more positive.

·         Currency strength is significantly determined by central bank action these days. With the US Fed planning to keep policy loose for the foreseeable future (and keen to have a weak dollar) and the ECB of the same mind-set, sterling may continue to be seen as an attractive option. The Swiss National Bank will also have to unwind its massive foreign currency reserves at some point, given that a significant amount of this is in euro it could weaken the currency.
·         In terms of impact on the UK, a weaker pound could aid the UK in terms of boosting exports. However, given our reliance on imports and the fact that a weaker currency could also see an increase in borrowing costs for the UK a decrease in foreign demand for our assets, the overall impact may not be positive. Sterling has devalued significantly since the start of the financial crisis with the boost to exports being minimal.
There is a good chance that sterling could weaken this year, which may not be good for the UK economy. However, the impact of a potential EU referendum in 2-3 years’ time on the currency should not be overstated. There are plenty of other more pertinent arguments to focus on both for the UK-EU debate and the analysis of sterling.
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