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Is GBP A Currency Crisis Waiting To Happen?

The idea that the UK is facing the possibility of a full-blown currency crisis has gathered increasing momentum since the start of the year, as GBP has continued to battle with the JPY for the dubious distinction of being the world's worst performing major currency (for the record, the JPY has once again pulled ahead in this race to the bottom). Speaking in Amsterdam last week, the Dutch finance minister, and president of the Euro Group, Jeroen Dijsselbloem warned "England is vulnerable…a new sterling crisis could happen again."

Before we get into whether such speculation is justified, or merely hyperbolic European schadenfreude, it is useful to first define exactly what a currency crisis is. Traditionally, a currency crisis is associated with fixed exchange rate regimes (such as the last UK currency crisis in 1992, when GBP was a member of the ERM), and occurs when speculators determine that the peg is unsustainable (normally because it overvalues the currency).

However, a currency peg is not a pre-requisite for a currency crisis, which may be defined as a "dramatic change in the country's nominal exchange rate" (Temin, 2013). As GBP has no formal peg, a currency crisis could perhaps be linked instead to its 'fair value', as measured by purchasing power parity. Currently, using the OECD methodology for calculating purchasing power parity, GBPUSD should currently be trading at about $1.47 on a 'fair value' basis (interestingly, despite the recent poor performance of GBP, it still trades at a premium to the USD; against the EUR it looks about 10% undervalued).

As such, if we use the USD as our benchmark, it would perhaps make sense to view any GBP depreciation of 25% or so below 'fair value' as a GBP 'crisis'; this would imply a GBPUSD spot rate of about $1.10. Such a level may seem implausible, but we have been there before; during the currency crisis of the mid 80's, GBPUSD hit a low of $1.03 (it had been trading as high as $2.40 less than 5 years previously).

So what could trigger a GBP crisis that could see such a significant currency devaluation? Traditionally, there are two (related) factors that can trigger a currency crisis: 1) an unstable external debt position; or 2) a declining level of national competitiveness (often resulting in a large and / or persistent current account deficit). I would also be inclined to add a third factor, in light of the current economic environment: the excessive use of unconventional monetary policy (i.e. quantitative easing) to stimulate the domestic economy. The bad news for the UK is that all three risk factors represent red flags for GBP.

As we have pointed out numerous times, the UK has a serious debt problem. In fact, when it comes to external debt (i.e. the amount of debt provided by foreigners), the UK is in a league of its own, even when compared to other currency crisis candidates, such as the JPY. This puts GBP at risk, as a capital flight out of GBP could be triggered if foreign investors lose confidence in the UK.

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However, when looked at on a net basis (i.e. when foreign assets, as well as liabilities, are considered) things begin to a look a little better. The UK's net liability position is 'only' 15% of GDP, which is very much in line with the European average - although much worse than the UK's 'high point', reached in 1986, when the UK actually had a net foreign asset position of 22% of GDP (amazing what a persistent current account deficit will do to your solvency!).

However, even when looking at the net position, there are some ominous warning signs for GBP. Notably, whilst almost all of the UK's foreign assets are denominated in foreign currencies, about 2/3rds of the liabilities are in GBP. Whilst this is good news from a solvency point of view ( a country it is much less likely to default on liabilities denominated in the domestic currency as it can just print more), it provides a strong incentive for the UK to devalue the pound. In fact, the GBP devaluation in 2008 resulted in an improvement in the UK's international investment position of approximately 34% of GDP!

It is also worth noting that while the UK holds a strong position in direct investments (net assets of +27% of GDP), it has a relatively weak position in portfolio investments (net liabilities of -38% of GDP). This is important when assessing the likelihood of a currency crisis, as portfolio investments are much more mobile (i.e. 'hot money') and susceptible to capital flight.

The second risk factor when assessing the probability of a currency crisis for the UK relates to productivity. A lack of domestic productivity can be a catalyst for a currency crisis for two reasons:

1) It leads to a current account deficit, placing direct pressure on the currency; and

2) It provides an incentive to devalue the currency to improve productivity.

Again, the signs are worrying for the UK on both counts. The UK has run a current account deficit (i.e. it imports more than its exports) since the early 1980's (which is one reason why its robust net asset position in 1986 has now become a net liability position, as highlighted above). Not only is this current account deficit position persistent, but it is deteriorating (it is now back to the highest level it has seen since the last current crisis in the early 1990s; about 3% of GDP).

In addition, UK productivity continues to lag that of other industrialized countries. As of 2011, UK productivity was 21% lower than the average of the rest of the G7, on an output per worker basis! The reason for this underperformance is not entirely clear (indeed, the 'productivity puzzle' has been one of the most widely debated economic issues in the UK since the financial crisis). However, this productivity gap does represent a clear and present danger to GBP, as the government and the Bank of England will be continually tempted to devalue the currency as means to reduce this gap. As the Sunday Times' Economics editor David Smith wrote last week: "I am no longer sure monetary policy is safe in (the Bank of England's) hands…short of erecting a sign on the front of the Bank saying "Sell Sterling" it could barely do more to signal its desire for a lower pound."

The third factor which threatens the integrity of the pound is current UK monetary policy, and the stated intention to, in the words of Chancellor Osborne, combine "fiscal conservatism and monetary activism" to resolve the country's economic woes. Regardless of whether or not this strategy is the right one for the country, what is clear is that this can be a lethal combination for the currency. Current government policy is, in effect, shorthand for debt monetization and currency debasement. Rather than borrow money to stimulate the economy, the government will simply print it instead. As a result, the extent of money-printing by the Bank of England currently dwarfs even that of Bernanke's Fed (QE represents 26% of GDP in the UK, versus a comparatively conservative 14% of GDP in the US).

As such, we cannot disagree with Mr Jijsselbloem. The risk factors are clearly in place for a sterling crisis: 1) a large external debt position, with foreign currency assets and domestic currency liabilities; 2) uncompetitive domestic economy; and 3) large scale unconventional monetary easing. Whether these factors actually lead to a sterling crisis in the coming months in less certain; it is unlikely that the UK government would like to see a disorderly currency depreciation (and the risk of initiating one may curtail their money-printing ambitions), and other currencies, notably the USD and the JPY, face problems of their own. However, it is important to at least consider the possibility of a sterling crisis manifesting itself in the coming months; it's not like it hasn't happened before.