With high hopes, the British people welcomed their new Prime Minister on Tuesday to the number 10. The next day (Wednesday), as Liz Truss was beginning her official duties as Prime Minister, the British pound plunged to its lowest point in 37 years.
As of Wednesday afternoon, the sterling fell to $1.1404. The last time the currency fell that much was in 1985 under Margaret Thatcher’s government. The closest it has come to that in recent times was in 2016 after the announcement of the Brexit result and briefly in March 2020, at the beginning of the global lockdown.
With a new prime minister in charge of the British affair, new economic and financial policies are expected to be in place in the coming days. What will these policies look like? Investors cannot say, but that could be why the sterling crumbled.
With the British economy facing one of the worse crises in a generation, investors are awaiting the decisions and reforms of the new government before beginning new investments. No doubt, the new Prime Minister has excellent plans for Britain, but the reality is that the leaders of most countries facing economic woes today also have good intentions for their nations.
The decisions by the 47-year-old could either curb the double-digit inflation rate or send the country to a worse situation than how his predecessor left it. The inflation rate in the UK hit 10.1% in July, which is the highest since Truss was 7 (40 years ago). She is expected to announce a £130 billion package to help ease the adverse effects of the soaring energy prices.
Once investors are sure of what the British monetary policies will look like under the new prime minister, the sterling could see a recovery. But the fear of a major fall is far from over.
The Fear of a sterling crisis
On Monday, the Deutsche Bank said there was a fear that the sterling could face some crisis following Liz Truss’s emergence as Prime minister.
“With the current account deficit already at record levels, sterling requires large capital inflows supported by improving investor confidence and falling inflation expectations. However, the opposite is happening,” Deutsche Bank said in a note Monday.
Two days after the statement, the sterling suffered a major blow. Although the sterling has not performed as poorly as other currencies, Shrevas Gopal, FX strategist of the Deutsche Bank, stated that a sterling crisis was still possible and should not be ignored.
Gopal suggested that the trade policies adopted by Truss could result in uncertainties that will affect investors’ confidence and in turn, cause more woes for the sterling.
“The risk premium on UK gilts is already rising, coincident with unusually large foreign outflows. If investor confidence erodes further, this dynamic could become a self-fulfilling balance of payments crisis whereby foreigners would refuse to fund the U.K. external deficit,” he said.
Although extreme, Gopal added that a balance of payments funding was likely. He said: “A balance of payments funding crisis … is not unprecedented: a combination of aggressive fiscal spending, severe energy shock, and a slide in sterling ultimately resulted in the U.K. having recourse to an IMF loan in the mid-1970s.”
“Today, the UK does retain some key lines of defense against a sudden stop, but we worry that the risks are rising nevertheless,” he added.
The route to a recession
The UK could be on its way to recession, and even the government knows that. The Governor of the Central Bank on Tuesday told members of parliament that as long as the war in Ukraine has not ended, the country’s chances of not entering a recession are slim.
When asked if there was anything the Bank of England could do to prevent the British economy from going into recession, Governor Andrew Bailey said: “Insofar as the war is having this huge effect, the answer to that would be no,” adding that; “the person going to put the UK in recession is Vladimir Putin, not the MPC [Monetary Policy Committee],”
Bailey said the growth recorded by the dollar and the weak British economy was putting pressure on the sterling. From Bailey’s explanations, it is clear that unless Truss makes extraordinary decisions, a recession is inevitable, and the fall of the British pound could go on and on.