A Pound in Your Hand is Worth?

April 15th, 2009

One of the impacts of the credit crunch is the fall of sterling against other currencies and in particular against the euro and the dollar.  This time last year the pound was worth nearly US$2 and €1.32 (source www.ft.com February 2008).  The reduction in the value of sterling is due in part to interest rates being lowered to try to stimulate lending.  This has however reduced the attraction of investing in sterling based deposits as the returns on these have also dropped and this, coupled with the fact that markets are concerned about the UK’s economic prospects, has adversely affected the value of the pound.

The obvious impact of this is that holidays to America or the euro zone will be more expensive as the pound in your pocket will not buy as much abroad, but there are other implications.

The reduction in the value of the pound can be of benefit for manufacturing and exports as the cost of buying British products is reduced however, the cost of manufacturing can increase if there is an increase in the price of parts.  This could be due to the fact that imports will become more expensive, pushing up the price of those goods sourced from outside the UK.  Oil is a good example to use to demonstrate this.   Oil is traded in US$ and if the current price of a barrel is about $40 and the exchange rate is $2 to £1 the cost of a barrel is £20, but if the exchange rate reduces to $1.40 to £1 then the cost of a barrel rises to £28.57.

This is not the first time the UK has seen depreciation in the value of the pound, two other years that spring to mind are 1967 and 1992.  In some ways the current situation resembles more closely the 1967 devaluation rather than the one in 1992 which was sparked by the UK’s exit from the Exchange Rate Mechanism.  In 1967 the UK was coming to the end of sustained economic prosperity and sterling had been overvalued for an extended period of time, we also had a Labour prime minister in the form of Harold Wilson.

Some fear that the current depreciation of Sterling will be followed by increased inflationary pressure however this may not be the case. Inflation could rise as UK goods are seen as competitive, increasing demand and therefore prices.  The potential increase in manufacturing cost due to more expensive imports could also help to increase prices however inflation may not necessarily be the case as in times of recession there can be enough room for this to be absorbed within the economy.  The UK is currently experiencing a fall in house prices and a shortage of credit – both of which would be expected to be precursors to deflation.  The current situation may actually therefore resemble more closely 1992 when rising inflation was not seen.

Of course no-one knows precisely what will happen, but if prices continue to fall in commodities such as food and oil and the UK remains competitive on exports then it is possible that some form of recovery could be seen.  When this is likely to happen is impossible to say, but the general consensus appears to be from 2010 onwards.  In the meantime, to help avoid the impact of the falling pound value, in part, you could buy British wherever possible.  By doing this there is no exchange rate to worry about, it will support the UK’s economy and maybe even help to kick start a recovery.