Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 28 October 2015

Is sterling overvalued?

One of the reasons that steel plants have been closing in the UK rather than Germany or France, and that UK manufacturing output has fallen for the last two quarters, is the strength of sterling and the weakness of the Euro. The weakness of the euro relative to the dollar could be explained (at least qualitatively) by interest rate expectations: whenever interest rates do rise in the US, they will surely rise well before they do in the Eurozone. When domestic interest rates are expected to rise relative to overseas rates, a currency should appreciate.

The same logic could be applied to sterling. Indeed some still believe interest rates could rise in the UK before they rise in the US. If the UK looks like the US, you would expect on these grounds for the pound relative to the dollar to be roughly stable, but sterling to follow the dollar in appreciating against the Euro. To a first approximation that is what has happened.

The only problem comes if you look at the UK’s external performance. The current account deficit as a percentage of GDP has wobbled around 2% for most of this century, but in the last few years it has increased sharply, coming in at over 5% of GDP in 2014. All these deficits are taking their toll on the UK’s net financial position: twenty years ago we owned about as many overseas assets as there were UK assets owned overseas, but we are now a net debtor by an amount that will just get larger if we continue to run large current account deficits. (For more on this, see Felix Martin in the FT.)

When I calculated an equilibrium sterling euro rate in 2003, my estimate was 1.365 E/£. As current rates are close to that, and given the point about expected interest rates, what is the problem? Unfortunately there are three. First, that calculation was based on an assumption that the sustainable UK current account was balance. In other words, if the rate had stayed at 1.365 E/£, then over time and on average the current account should have been in balance. Instead we have had persistent deficits. In the early 2000s that might have been partly explicable because sterling was a little stronger than my estimate, but since the beginning of 2008 quite the reverse has been true, but we have still run deficits. That either suggests my estimate was wrong (the equilibrium E/£ rate should have been lower), or the equilibrium rate has depreciated since 2003.

Second, persistent current account deficits that weaken our net foreign asset position will in any case imply a gradual depreciation in the equilibrium exchange rate. The worse our net asset position gets, the greater the trade surplus we need to pay interest on that net debt. Third, and perhaps more speculatively, if the recent stagnation in productivity also represents a stagnation in innovation in the variety and quality of goods produced in the UK, that will also mean a depreciation in the equilibrium exchange rate.

All this suggests to me that sterling may currently be overvalued. How can I say this when there are a huge number of people in that market trying to make money from getting the ‘right’ rate? Quite simply from experience. The market is totally focused on very short term movements, and pays very little attention to estimates of equilibrium rates. When I did my equilibrium rate calculation in 2002, the actual rate was wandering around 1.6 E/£, and there was no clear reason why it should be so much higher than the equilibrium rate. So, even allowing for expectations about interest rates, it would be quite possible for sterling to be currently overvalued.          


  1. If this is in response to my query about some recent stuff posted by John Mills, thankyou.
    If not, I'm very curious to know what you think about how the exchange rate influences the balance between manufacturing and services (particularly financial services) in the UK.

    thanks again.

  2. Difficult to know for sure, but that looks right to me.

    What I do know is that £700k will buy you something like this in the UK

    or this in France

    (The latter is not even a particularly spectacular example.)

    Which is a bit odd, even taking into account different size of country, increases in population, concentration of jobs in certain areas etc etc.

    My advice is sell up and buy somewhere nice in France where the weather is better before the £ inevitably falls. You can blog from there.

    1. Good thinking SH. According to the Big Mac index, the pound is overvalued by 6% against the Euro but only 1.3% against the US Dollar. Very overvalued against the Yuan and the Yen .
      Foreign exchange "gambling" markets, have little to do with foreign currency trade fundamentals. In four days, enough currency has been traded to finance a whole years worth of international trade in goods and services.

      Interesting piece on applying Tobin Q factoring to residential property. I wonder what the factor is in Oxfordshire. I read that house prices are now 16 times income!!!???

    2. Sorry, forgot the link.

  3. I have a couple of questions about this. One, doesn't the selling off of British assets mean that future revenue streams from those assets are increasingly heading overseas? Two, what happens when we run out of assets to sell to foreigners?

    1. I agree with Mike but would add: Three, what happens if foreigners decide that the big rise in our asset prices is a bubble and decide to try to get their money back?

  4. SWL: "In other words, if the rate had stayed at 1.365 E/£, then over time and on average the current account should have been in balance. Instead we have had persistent deficits."

    But this has a lot to do with internal demand weakness in the Eurozone (UK main trading partner). Eurozone trade balance in goods and services went from zero in 2012 to +3% of GDP. This happened mainly before the euro depreciation. Most important reason was austerity reducing demand and imports.

  5. Theory also tells us increasing the UK's budget deficit should put upward pressure on the value of sterling. What is your assessment of that?

  6. Over the long term, the current account deficit should be close to 0, if the currency is to be competitive. That would mean that £ has to devalue quite substantially against the Euro.

    To do this we need lower interest rates than Euro interest rates. But, given the UK's better economic performance it is likely that rates rise before they rise in Europe. That would worsen the current account deficit, as it would strengthen the £ exchange rate.

    Which leads to the following question:

    (1) should a monetary policy (level of interest rates) not primarily be concerned with trying to achieve a long term equilibrium in the current account? Therefore leaving interest rates as low as possible, even if it means having inflation rates higher than the 2%.

    (2) What should a monetary policy look like, if the devaluation of the currency cannot be guaranteed, because Euro interest rates and UK interest rates are both 0%?

    1. For your point (1): what matters for the current account (at least the trade balance part of it) is the real exchange rate, not the nominal rate. So allowing infaltion to rise will not help, unless the nominal exchange rate is not just at a lower level, but is falling continuously.

  7. What has happened Simon is large eurozone exporters have lower their prices in GBP terms. This causes "deflation" in UK and leads to lower exchange rate.
    Standard line:
    "Forex traders have very limited influence on the exchange rates... the rate is dominated by what the exporters/importers will offer/bid in the different currency terms... "

    Which is interesting because that is, of course, exactly the opposite of what most economists believe - that the volume of trades is what moves the price.

    However when it comes to settlement the only people that actually need the forex are those doing actual buying and selling. Everything else is a zero sum game - so of course it pulls towards what importer/exporters want unless there is a patsy central bank doing daft things in the background.

  8. Matt, you have this wrong. I suggest you read:
    The exchange rate is up due to forced saving from the export side. Sterling is overvalued because of this. Nowt to do with interest rates.

  9. Beware economists second-guessing markets; markets are almost always smarter than you think.

    I found these links very informative on the trade balance issue. The US has run trade deficits for decades yet this appears sustainable. Why? Foreigners trade high-yielding foreign investments for low-yielding US investments. The US is a "net exporter" of safety and liquidity. I put "net exporter" in quotes because of course this is not the way national income accounting works, so it looks like there's an imbalance when there is not. See:

    Kenneth Duda
    Menlo Park, CA

  10. Communication, re: mediamacro.

    Simon, have you heard yesterday's Hardtalk with Ben Bernanke ( Sackur went on with rare ignorance repeating Hayekian nonsense on the alleged depressive effects of monetary expansion on real investment, folkloristic metaphors involving the usual money=drug comparison and confident speculation about the "clear need" of massive structural reforms as an alternative diagnosis for the whole experience. Most stunning of all, he was almost unchallenged in doing so. Clearly restraining himself, Bernanke kept an overall low profile and avoided to debate the substantive issues underlying the questions asked. The overall message to the uninformed audience is again one of a witty, contrarian journalist putting a jargon-ridden bureaucrat into difficulties. Bernanke replied, but did not always contradicted Sackur, let alone provided explanations as for why the questions asked were marred by errors. What about beginning to make names, or starting a collective blog quoting each single of such episodes on public broadcasting and debunking it?

    Yours truly,
    an economics phd student in London

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  12. Remember kids, a weakening £UK means that import costs (typically $US-based when traded globally) increase, harming UK industry.

  13. "When domestic interest rates are expected to rise relative to overseas rates, a currency should appreciate"

    Good to see you believing in the power of rational expectations to move both financial prices and the real economy ... just like targeting NGDP Forecasts. And, yes, I do see later in the post that you think the markets can be a bit short-termist, too. The long term is just a succession of short-terms.

    More seriously, you seem to imply a growing burden of interest on foreign debt. But where is that debt? The UK government has hardly any foreign debt, nor do UK households or UK corporations.

    And, why the obsession with manufacturing. Why the bias against human capital?

  14. Consider the behavioural aspects:
    No matter how much we like to believe that "the market" sets the GBP rate, minute by minute the quote is bid-offered by the dealers, primarily in London. Remember the Triennial Survey...over USD5 trillion per day traded in FX, with most in London. Current account trade pales in comparison. These dealers are compensated in GBP. Would it be wise for these dealers to allow GBP to fall against major international curriencies? These are jet-setters, after all, and need to have ski vacations in exotic places, imported luxuries, etc. Any extra bonus compensation on betting on lower GBP, and being right, would be out-weighed by the loss in international purchasing power. Such is the real world of "the markets." I suggest we replace names like "efficient markets" with a new term for the same old game: "Manipulated Markets Theory."

  15. My guess is that the strength of the British financial sector keeps the Sterling higher than it is good for the UK. The financial sector has an interest in keeping its home currency solid, another reason why interest rates can't increase quick enough for them. London real estate transactions are being done in Sterling, I would guess? If the UK only consisted of Greater London that would be ok, but since it's not, it's just another instance of the financial sector strangling the rest of the UK.

  16. Not strictly relevant to this post- but I wondered if it might be the topic of a forthcoming post... David Cameron in his recent PMQs on 28.10.2015 says 0% inflation is a benefit to the economy... Why do you think he says that? Maybe he was swept up in the rhetorical thing of saying 3 things in a row...

  17. A while back I commented on the fact that Conservative governments start out, (for three years) with the "slash and burn the public sector" mantra. This manifesting itself in the nation having to prostrate itself before the great "God of Austerity". Thatcher; Major and Osborne (twice) in the last three decades alone.

    The OBR, (Office of Budget Responsibility) which has become the government sponsored wing of the IFS (Institute for Fiscal Studies); has had to come a little bit clean. The storm clouds are gathering over the Osborne Austerity religion. A lot of laissez faire, neo-liberal, Conservatives, the ones that have H-A-T-E tattooed on both knuckles; are wishing to repent, using the Kurt Waldheim defence, (we were only following orders).

    To cut a long story short, have a read of . But read the two OBR links in the text for the full story.

  18. Sterling is always overvalued. Ask George Soros.


  19. so how does your theory relate to the shift of supply and demand curve to reach the equilibrium price?

  20. Probably not.
    But if it is, it will sort itself out soon enough.

  21. If a foreigner buys a house in the UK, that's part of the capital account and not the current account, right? So why does the current account being negative imply that sterling is overvalued, since there are lots of foreigners buying property in London and Cambridge? Instead of manufactured goods shipped abroad, the UK is selling real estate. No?

    Anyway, mechanically QE depresses the exchange rate, and it's seems reasonable that when QE stops the exchange rate will become overvalued. Both the US and the UK responded to the 2008 crisis by using competitive devaluations. But they did it in such a way that the devaluation wasn't permanent, and revaluation now follows. My two cents, anyway.

  22. Do you think that if the interest rate was lowered (by whatever means) to what Krugman et al suggest is the real interest rate (ie negative), would sterling be more affected? If so would this be desirable?

  23. How do you think the sterling being considered overvalued has affected the GDP of countries in the Eurozone? With an appreciating sterling, should we be more worried about a depreciation in the equilibrium exchange rate or a fail in an attempt to bring back up the equilibrium?

  24. That's not really how it works you guys. You can't spend it on imports to excess unless foreigners are prepared to hold the financial assets that allow the finance arm of the transaction to complete.

    The transaction fails unless the real transaction *and* the corresponding financial transaction complete end to end *at the same time*.

    So the existence of excess imports necessarily implies that foreigners are prepared to hold the financial assets. Otherwise there simply wouldn't be any excess imports in the first place.

    The desire for imports may bid up export earnings, and all that means is that domestic exporters have to swap out less of their foreign earnings to get the necessary domestic currency to pay their costs.


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