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Why a strong pound is to be welcomed rather than feared

A strong pound has normally been associated with a strong UK economy

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The pound has strengthened significantly against the euro in the past couple of years Photo: Alamy

Is the pound too strong? The strength of sterling is being cited as a problem by a number of the steel companies in difficulty at present. Recent comments from the CBI and the Engineering Employers’ Federation also suggest that a rising pound has hit manufacturing exports and production more generally.

The first question to ask is whether the value of the pound is unusually high by historical standards; and looking at the evidence, the answer is “no”.

Europe is a key market for UK manufacturers and the pound has strengthened significantly against the euro in the past couple of years. The average value of sterling against the euro so far this year has been around €1.38. That is about 18pc above the average sterling-euro exchange rate of €1.17 in the five years 2009-13. But before the financial crisis, between 1999 and 2007, the pound was worth around €1.50 – a period when the UK economy grew strongly and unemployment was low.

Since the euro came into being in 1999, the average value of the pound against the European currency has been €1.38, very close to its current value. Taking a long-term view, therefore, sterling does not appear overvalued in relation to our major European trading partners.

Nor is the pound particularly strong against the US dollar. The United States is the UK’s largest national export market, accounting for 13pc of our overseas sales of goods. Many other economies link their currencies to the dollar – including China and countries in the Middle East.

Looking back over the 15 years since 2000, the value of the pound against the dollar has averaged just over $1.65, compared to the current rate of around $1.55. So against the world’s most important currency, the pound is actually below its par value at present.

These comparisons suggest that the current value of the pound is around its average value against the euro and may be slightly undervalued against the dollar. In the aftermath of the financial crisis, we experienced a period of about five years when the pound was weak, as we did after the UK left the European Exchange Rate Mechanism in the early 1990s. But sterling has now returned to a value close to longer-term historical norms.

So what should be the UK policy on the value of the pound? Should we be trying to influence the value of our currency on foreign exchange markets? And if so, in which direction?

The current value of the pound is around its average value against the euro and may be slightly undervalued against the dollar

There have been times when the value of the sterling exchange rate has been an important anchor for UK economic policy. From the late 1940s until the early 1970s, Britain was part of the Bretton Woods system of fixed exchange rates. The pound was fixed at $2.80 from 1949 until 1967 and then at $2.40 until the early 1970s, when the Bretton Woods exchange rate system broke up.

From 1985 until 1992, the value of the pound against the Deutschmark and other European currencies once again became the focus of UK economic policy. When Nigel Lawson was Chancellor, the UK “shadowed” the Deutschmark and then – under his successor John Major – joined the Exchange Rate Mechanism (ERM).

Since we left the ERM in 1992, however, the UK has had to live with the value of sterling that the market has delivered. When the euro was formed in the late 1990s, Britain did not join. The pound has fluctuated against the euro, the dollar and other currencies. As Margaret Thatcher once commented: “There is no way you can buck the market.”

Despite all the ups and downs in the value of sterling in recent decades, the British economy has done relatively well. The UK is still the 5th largest economy in the world, behind the US, China, Japan and Germany.

Bundle of euro bank notes leaning against a savings box infront of the twin towers of the Deutsche Bank in Frankfurt, GermanyThe pound has fluctuated against the euro, the dollar and other currencies  Photo: EPA

Currency fluctuations are a part of business life, and well-managed companies must find ways to cope with them. Exchange-rate hedging – buying currency forward to cover future transactions – is one strategy. Another is to exploit “natural hedging” – structuring contracts to balance payments and receipts in foreign currencies. It is also important that businesses base their strategic investment decisions on a long-term view of the exchange rate and are not lulled into a sense of false security by a period of temporary strength or weakness in the currency.

A low or weak exchange rate does not necessarily help the economy. Japan has recently tried pushing down its currency under the economic programme of Shinzo Abe, known as “Abenomics”. But this has not boosted economic growth. Instead, it has pushed up the price of imported goods and squeezed consumer incomes. Economic growth under Japanese “Abenomics” has been disappointing. In 2014 the Japanese economy contracted by 0.1pc and this year GDP is expected to grow by less than 1pc. In the next five years, the IMF expects Japanese economic growth to be just 0.5pc-1pc per annum.

In the UK, healthy economic growth has normally been associated with a relatively strong exchange rate – and we have seen this pattern repeated recently. The pick-up in the British economy since 2011-12 has been accompanied by a stronger pound.

Though manufacturers do not always welcome a strengthening currency, it can help the economy in other ways. A rise in the value of sterling pushes down the cost of imported consumer goods and the energy, commodities and components that businesses buy from abroad. It holds down inflation – as we have seen recently – and supports the growth of disposable income and consumer spending. We saw evidence of this in the retail spending surge reported last week.

Manufacturers do not always welcome a strengthening currency  Photo: GETTY IMAGES

As long as the pound does not become significantly overvalued, a stronger currency should be good for growth. The bulk of our exports are now generated by hi-tech and services industries, which are not too sensitive to exchange rate movements. There are some exceptions, and the steel industry is one of the more price-sensitive sectors which is vulnerable to a strengthening exchange rate. But even here, there are other factors hampering business prospects apart from sterling – including the world steel glut created by the slowdown in the Chinese economy.

A strong pound has normally been associated with a strong UK economy. We should not fear the recent strength of sterling – but embrace it and adapt to it.

Andrew Sentance is senior economic adviser at PwC and former MPC member.

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This entry was posted on October 24, 2015 by and tagged , .

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