Double dip or debt crisis for the UK? Sterling heads lower

February 22, 2010

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-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The UK may have clawed its way out of technical recession, but over the course of last week data releases highlighted a sharp drop in retail sales and a surge in the claimant count, a spike higher in the inflation rate and record public sector borrowing.

Poor weather and a hike in VAT may have contributed to the poor performance of the retail sector in January.  Even so, with the labour market taking a turn for the worse perhaps it would be optimistic to assume that the consumer sector will remain anything but weak going into the spring.

These data force the question of how sustainable the UK economy recovery will be in 2010 if fiscal support is rapidly withdrawn.  This debate is already intensifying ahead of the spring general election.

From a policy perspective there may exist a fine line between the right amount of fiscal austerity and positive growth that would bolster investor confidence and the pound but given the risks on either side of this could swing as far as a debt crisis (if no austerity is introduced) and a double dip recession (if too much austerity was seen), in all likelihood sterling buyers vs the U.S. dollar will remains scare into the spring and most likely beyond.

The February CBI industrial trends survey provided one of the first pieces of evidence that the weaker pound was having an impact on lifting UK exports.  Official data are yet to show any convincing evidence that the external sector has benefitted even though the sterling effective exchange rate  has recovered only a modest amount of the drastic 30 percent decline recorded between mid-2007 and late 2008.

It may be disappointing that the benefits of a weaker pound have been so long in coming, but with the UK budget deficit/GDP ratio this year set to potentially outstrip that of Greece this year, a flexible exchange rate is likely to prove to be an invaluable support to the UK economy and one that the Greek government may come to envy.

In order to increase its competitiveness the Greek government faces having to slash the number of public sector workers and/or their wage and pension entitlements to restore its budget to an acceptable equilibrium; a feat which it could fail.  There is absolutely no doubt that the next couple of years are likely to be tough going for the UK too but blow to the UK economy should be lessened by the competitive advantage that should be offered by a weakened pound.

There is the risk that sterling weakness may increase inflationary pressures in the UK.  Theoretically this could lead to the Bank of England pushing short-term rates higher sooner rather than later which would hamper growth.  There is no strong correlation between the UK’s effective exchange rate and the CPI although the spike in UK CPI into Q3 2009 was probably fuelled by the weakness in the pound particularly via its impact on oil imports.

That said the Bank maintains that CPI will fall below its 2.0 percent y/y inflation target by the end of its forecast period with high levels of unemployment and excess capacity set to continue bearing down on prices.  If the Bank’s inflation outlook proves to be correct then the boost to the economy provided by the weak pound should more than vindicate the UK’s decision to remain outside of the EMU.  

There are currently no guarantees that Greece will not succumb to the draw of a flexible exchange rate as a consequence of its current fiscal crisis.

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