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Commentary: Does BoE's hawkish lurch nod to "sterling crisis"?
September 20, 2017 / 1:44 PM / in a month

Commentary: Does BoE's hawkish lurch nod to "sterling crisis"?

The Bank of England is seen in the City of London, Britain, August 23, 2017. REUTERS/Hannah McKay

LONDON (Reuters) - As the Bank of England sends its strongest signal to date that the first interest rate hike in a decade is approaching, could Britain be heading towards its first sterling crisis in a quarter of a century?

At first glance, there appear to be few parallels between now and 1992, when George Soros famously “broke the Bank of England” and the pound chalked up what was then its biggest one-day loss of the floating exchange rate era.

That dubious record was smashed on June 24, 2016, after Britain voted to leave the European Union, but there has been little talk since of a “sterling crisis”, and the weaker pound has been broadly viewed as a welcome safety valve, keeping asset markets attractive to foreign investors while buoying export and corporate earnings without forcing up interest rates.

So what then constitutes a sterling crisis? And does the Bank’s sudden hawkish turn to offset the inflationary effects of a weak pound bring Britain closer to one?

There’s no agreed definition of a sterling “crisis”, but one common element is that persistent sterling selling or weakness forces up interest rates, hits asset markets and potentially hastens recession. In effect, rates are forced higher to defend the pound or to bring imported inflation under control, regardless of the economy’s ability to withstand that monetary tightening.

Some might argue that’s now happening with a 15-month lag, although no one at the Bank will ever admit that the exchange rate determines policy, despite it being the main reason the Bank is failing in its sole mandate: controlling inflation.

There have been at least four sterling crises in the last 50 years - 1967, 1976, the mid 1980s and 1992 - where interest rates were jacked up aggressively in ultimately unsuccessful attempts to defend the currency.

A doubling of interest rates from a record low 0.25 percent currently to 0.5 percent would only reverse the emergency cut shortly after the Brexit referendum last year. Even another quarter point hike would be laughably miniscule when set against the steep rate increases of crises past.

But it would represent a doubling or trebling of official borrowing costs, greater magnitudes of increase than those four crises past.

SOROS, 1992 AND ALL THAT

In November 1967 rates were jacked up to a then-record 8 percent from as low as 5.5 percent only a few months before the government buckled under the mounting pressure on the currency and devalued the pound to $2.40 from $2.80.

In October 1976 the government raised rates to 15 percent - also a record at the time - to ease pressure on the pound. The ploy failed and the International Monetary Fund came to the rescue with what was then its biggest ever loan for any country. Sterling lost around a quarter of its value between April and October that year, sliding to $1.56 from over $2.00.

In January 1985, with sterling plunging towards parity with the dollar, finance minister Nigel Lawson pushed rates up to 13.875 percent from 9.5 percent. The dollar was soaring globally, but in Britain the talk was of a sterling crisis.

On the morning of 16 September, 1992, the Treasury raised rates to 12 percent from 10 percent and in the afternoon promised to lift them to 15 percent, in a doomed effort to ward off billionaire financier George Soros and other speculators.

Soros bet that the Bank would fail to keep Britain in the Exchange Rate Mechanism, the precursor to the euro. He was right: Britain crashed out of the ERM, the BoE blew billions of pounds of its foreign reserves, sterling plunged and he made himself an even bigger fortune.

The common thread running through these episodes isn’t just the exchange rate - it plunged 30 percent in 2007-09 without gaining the “crisis” tag - but that interest rates were forced higher to prevent sterling’s persistent weakness feeding above-target inflation.

The absolute levels and starting points are lower and less dramatic today, but that’s essentially where the Bank is: struggling to control exchange rate-fuelled inflation and worried that domestically-generated inflation could follow.

Again, high inflation itself isn’t what determines a sterling crisis. That comes onto the horizon if it prompts the higher rates that threaten to tip UK financial and property markets over, dry up overseas demand for UK assets or push foreign investors in Britain towards the exit.

So far, the only sign of chinks in that armour is in London property. A survey last week showed that house prices in central London, which are largely driven by demand from wealthy foreign buyers, fell in August at their fastest pace since 2008.

That could be explained away by overheated valuations - but the price falls have come despite the currency being 15 percent cheaper for overseas buyers.

Bank of England figures show that foreign demand for UK government bonds has softened this year. In the seven months to July, foreign investors bought 1.7 billion pounds of UK gilts, compared with 6.24 billion pounds in the same period a year ago.

Having one of the developed world’s biggest current account deficits means Britain relies on “the kindness of strangers”, in the words of BoE governor Mark Carney, to balance its books.

Last year the deficit was 4.4 percent of gross domestic product, meaning Britain needed about $100 billion from abroad.

The opinions expressed here are those of the author, a columnist for Reuters. 

Reporting by Jamie McGeever; Editing by Gareth Jones

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