* UK no stranger to a currency crisis
* Britain depends on “kindness of strangers”
* Sterling on course for second biggest yearly fall since 1970s
By Jamie McGeever
LONDON, Oct 7 (Reuters) - Sterling’s slump to its lowest in more than 30 years against the dollar this week in increasingly volatile trading has raised fears Britain’s exit from the European Union could yet trigger a currency crisis like those of 1967, 1976 or 1992.
By some measures, such as the speed of the losses and volatility of its market trading, the pound is showing crisis-like symptoms. Most market observers expect it to fall further on the foreign exchanges before it stabilises.
But for a classic ‘currency crisis’ to unfold, sterling losses would have to choke off the foreign portfolio investments critical to balancing the economy’s massive external payments deficit. That risks a spiral of selling of UK bonds and stocks, sinking the currency further, stoking inflation and complicating the central bank’s ability to ease credit more if needed to support the real economy.
For investors fearing such a vicious circle there were worrying signs on Friday that overseas holders of UK assets may be losing their nerve. The last three days have seen UK government bonds and domestically-exposed mid-sized stocks fall in tandem with the pound for the first time since the immediate aftermath of the Brexit referendum.
The selling has not yet turned into a rout, however. Few observers are flagging a match with prior sterling crises just yet, even if the economic, political and financial uncertainty unleashed by Brexit is likely to cast a dark cloud over the currency for some time.
The crisis in 1967 saw sterling come off the gold standard and devalue; in 1976 Britain was forced to seek a multi-billion dollar aid package from the International Monetary Fund; and in 1992 billionaire investor George Soros famously “broke the Bank of England” when Britain was ejected from the Exchange Rate Mechanism, the pre-cursor to the euro.
Market veterans reckon for the current turmoil to turn into a crisis, there would have to be clear evidence foreign funds and central banks were losing faith in the UK economy and policy framework, and offloading their UK assets accordingly.
Britain has the biggest current account deficit in the developed world at nearly 6 percent of its annual economic output. In the words of Bank of England governor Mark Carney, it relies on the “kindness of strangers” to fund the gap.
If that flow of capital from abroad dries up, Britain has a problem. This has been the root cause of most emerging market currency crises in recent decades, notably in Mexico in 1995, Thailand in 1997 and Brazil in 1998.
“This is not a sterling a crisis, but it has the potential to become one,” said Nick Parsons, global co-head of FX strategy at National Australia Bank, and a 30-year veteran of the currency market.
David Bloom, global head of FX strategy at HSBC, agreed, noting that overseas investors have not called time on UK Plc.
“Foreign holders of UK assets will not be worried, at least not yet. This is an adjustment. Nobody should be surprised. Adjustments can be smooth or they can be rocky,” he said. “But policymakers will be concerned.”
Sterling plunged to a fresh 31-year low of $1.14 from $1.26 early on Friday before quickly recovering most of that ground. The Bank of England said it is investigating the cause of the short-lived fall.
The volatility comes at the end of a tumultuous week, kicked off by Prime Minister Theresa May saying said she would trigger the process to leave the EU by the end of March. Markets took fright, interpreting this to mean there will be a “hard” Brexit with Britain having less access to the European Single Market.
Investors were also taken aback when May criticized the “bad side effects” of the BoE’s low interest rates and bond-buying. Aides said she was not trying to influence Carney but some saw the comments as a warning to the Canadian who is in the process of deciding whether to extend his governorship of the BoE beyond his scheduled departure in 2018.
The yield on benchmark 10-year British government bonds shot up above 1 percent from 0.70 percent a week ago, still low by historical levels but reflecting investors’ fears that the weak exchange rate will fuel an inflation boom.
Inflation expectations as measured by the so-called five-year, five-year forwards jumped to 4.5 percent, the highest since the June 23 Brexit referendum.
Alan Clarke, an economist with Scotiabank in London, said sterling’s post-referendum fall was set to add up to 2 percentage points to consumer price inflation, which he now thought would peak at 2.6 percent in November 2017. Inflation was 0.6 percent in August.
The pound is one of the worst-performing currencies in the world this year. Since the referendum, it has fallen 17 percent against the dollar and euro. On a trade-weighted basis, it is down 18 percent this year, putting it on course for its second biggest annual fall since the 1970s.
So far, the BoE has sat on the sidelines and allowed sterling to find its own level. Many argue that the Bank’s post-referendum interest rate cut and revival of its quantitative easing bond-buying programme has turbo-charged the pound’s fall.
UK finance minister Philip Hammond said on Friday that the pound’s fall this week reflected investors’ realisation that Brexit is a cold, hard reality. He expects more “ups and downs”.
“A crisis is when there is a sense that the falls in sterling reflect a lack of confidence about the UK’s economic prospects and/or the economic policy framework, rather just a benign - i.e. stabilising - response to shocks,” said Charlie Bean, former chief economist at the Bank of England.
It’s hard to imagine the Bank intervening directly in the FX market now to prop up the pound like it did in 1992. Then, it blew billions of its FX reserves in its ultimately futile battle against Soros and the market.
BoE deputy governor Broadbent said this week that the Bank could, “in principle”, reverse its ultra-loose policy and raise rates if sterling’s fall was sufficiently steep and rapid. But few analysts believe that is on the cards.
Sterling’s all-time low against the dollar is around $1.05, struck in 1984. That’s around 15 percent from current levels and as the last three months show, it’s not out of reach. Parity against the dollar or euro would certainly ring alarm bells for the government and the Bank of England.
“When the pound is worth less than a dollar or less than a euro, there’s no doubt that is a sterling crisis,” Parsons at NAB said.
Reporting by Jamie McGeever; Additional reporting by William Schomberg; editing by Mike Dolan and Peter Graff