Most prospective prime ministers would be mildly embarrassed if a boost to their chances made financial markets plunge. But Boris Johnson is doubtless gratified that his backing for Brexit led to the pound’s biggest one-day fall since the aftermath of the financial crisis. Sterling had barely flinched when cabinet ministers including Michael Gove and Iain Duncan Smith made their own interventions a day earlier.
The improbably popular Johnson’s Eurosceptic turn has been initially viewed as making Britain’s departure from the EU more likely. It also confronts already-volatile financial markets with two new uncertainties: whether British voters will now give up on the 28-member bloc, and what sort of economic and political arrangements the UK can expect if it chooses to leave.
Sterling had initially risen when David Cameron revealed his renegotiated EU terms on February 19, and further falls are likely to be interspersed with more rallies before the referendum on June 23. The pound will remain unusually turbulent in the next four months, with the likelihood of a continued downward drift.
Markets already have to wrestle with the question of how easily the UK could retain its present free trade and free capital movement arrangements with the EU (and those it currently enjoys through the EU’s external treaties). Johnson’s own announcement has also stoked up fears that a Brexit could spark the break-up of the UK itself. If a decisive vote to leave comes only from England and Wales, it is possible that governments in Scotland and even Northern Ireland might try to retain some sort of EU integration.
Some analysts foresee even greater turmoil as the EU struggles to stay intact without its second-largest member. EU economic recovery could be further threatened as UK financial institutions exploit regulatory advantages over the eurozone’s still-problematic banking union plans. This post-Brexit threat to the remainder of the EU is the overarching fear. The pound and euro could both be expected to depreciate against the dollar, already regaining its safe-haven status after its interest-rate rise, and the loss of momentum by China and other emerging markets.
In truth, the pound could be expected to drift downward, even without Brexit fears. There are external imbalances between the sterling and euro areas. Despite rebalancing efforts, the UK is still running a large current account deficit – buying more from abroad than it can sell – while the EU (even with Britain) has a persistent external surplus thanks to Germany’s export machine.
Although capital inflows have long kept the pound relatively immune to this chronic excess of consumption over production, and rose in 2014/15, 40% of last year’s “greenfield” inward investment – assets that are newly created and not just taken over – came from elsewhere in the EU and could be jeopardised by exit.
Meanwhile, a sharp fall since 2011 in returns on the UK’s outward investment is offsetting any improvement in export performance. These trends are likely to keep downward pressure on the pound, even if a Brexit does not immediately lessen the UK’s attractiveness to foreign investors globally.
The present and future UK governments are unlikely to resist continued slippage of the pound against the euro, or even the dollar, since this depreciation has played an important role in getting the economy growing again after the 2008-9 recession.
The Treasury traditionally resisted such currency slides because they raised inflation (by making imports more expensive) and the cost of servicing foreign-currency debt. But with oil and other commodity prices already low and set to sink further, recovery is now more under threat from stable or falling prices than from inflation getting too high. And the UK’s opt-out from the euro, already in its membership terms, dampens its external debt concerns by enabling it to keep most national debt in its sovereign currency, a luxury the eurozone members have given up.
With one mighty leap…
As always with short-term forecasts, it’s also possible that the pound will soon pick up again, even if the referendum result stays highly uncertain or keeps shifting towards Brexit.
This could happen because some market traders accept the most optimistic Brexit scenario, under which the whole of the UK (unleashed from EU regulations) becomes Europe’s Northern Powerhouse. It could also happen if, whatever their misgivings about a newly independent UK, analysts foresee an even gloomier future for the rest of the EU. Some entertain the idea that it will sink further into slow growth and rising debt because of its over-extended and inflexible currency union, or be returned to a mess of fragmented economies and competitive devaluations if it allows the present eurozone to break up.
But as ongoing EU membership was fully priced-in to the UK’s main exchange rates until recently, repeats of this week’s slide are likely until markets reach more consensus on what life would be like outside it, whether or not a triumphant “Leave” campaign catapults Boris Johnson into Number Ten. Another reason – beside the memory of pre-1973 passport controls – to bring forward any European holiday plans.