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.
