Commentary
Last week’s fall in the British pound was said to be a reaction to Britain’s new Prime Minister Liz Truss’ proposed tax cuts. Exchange rates represent the purchasing power of money. Anything over that amount will be depreciated. Governments planning to fill their budget deficits by printing money will be forced to devalue their currencies. Here is the story behind the Stirling Crisis. Although it seems simple, there are technical problems in operating such hypotheses. In addition, there are factors outside the fiscal sector that affect exchange rates.
Fiscal deficits are common everywhere, especially in developed countries. The UK has a budget deficit, and the US has a similar budget deficit. Therefore, the correct explanatory variable should be the difference or ratio between the US and UK government budget deficits. A standard normalized representation of it is the budget deficit expressed in GDP. This has the advantage that the ratio is unitless since both deficit and GDP are in local currency. Therefore, it is easy to find the deficit-to-GDP difference between the UK and the US.
In theory, the bigger the deficit, the worse the exchange rate. Deficits are displayed as negative, and the more negative the domestic-to-external deficit-to-GDP ratio, the lower the exchange rate. So from the attached chart, we should see a co-movement between the blue and red lines if the theory is practical. But her two correlations in the past suggest that the fiscal balance gap between the UK and US has led the Sterling dollar by about two years. In other words, the budget balance somehow predicts exchange rates, and has been for quite some time.
Nevertheless, the correlation is somehow broken since 2016/18 (blue/red). The UK’s financial situation has improved significantly compared to the US since Brexit (2016). However, the British pound against the US dollar (GBP/USD) has not risen accordingly. One of the reasons is that the Federal Reserve raised interest rates by her 2.25% (9 out of 25 basis points) while the Bank of England raised them by only 0.5%. Such a widening (negative) UK-US rate gap is weakening GBP/USD as exchange rates are tightly controlled by interest parity.
From mid-2020 to the latest reported quarter (Q2 2022), the deficit and GDP gap between the UK and US narrowed from +4.8% to -0.5%. The reason is not the deterioration of Britain. In fact, the figure has improved from his early 2021 minus 14.7% to the latest minus 4.8%. Instead, it was the US that did better, but not by much. It went from -16.8% to -4.3% over the same period. It can be seen that the financial situation of the two is very similar. From a long-term perspective since 1984, the average of the gap (blue line) is almost zero, and the most recent value is actually very close to zero.
It turns out that GBP/USD did not rise as the fiscal balance suggests. By contrast, he may not see GBP/USD fall solely due to a worsening UK budget deficit. There seem to be quite a few factors other than deficits in the ‘GBP Crisis’, such as the unwinding of risk-off assets.
Views expressed in this article are those of the author and do not necessarily reflect those of The Epoch Times.
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