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Why is the British pound dropping and why does it matter?

03/10/2022


This news was written by Kavinash Mautadin-Marin. Kavinash Mautadin-Marin is a first year student at Queen Mary University of London studying BSc Economics.




What has happened?

The British pound has fallen to a record low against the dollar following the major tax cuts announced by the Chancellor of the Exchequer, Kwasi Kwarteng, on Friday 23rd September. Markets did not respond well to his plans to scrap the corporation tax increase from 19% to 25% and reduction in the basic rate of income tax by 1 percentage point to 19%, along with others, resulting in the value of the pound tumbling steadily from $1.12 until reaching $1.04 - a record low for the pound since 1985.

Why has it happened?

The main reason for this significant event derives from speculation of currency investors. Investors buying the pound to later sell for profit have doubts on whether the government will be able to fully repay the loan needed to fulfil these tax cuts. Herding effect has also arguably played a role in the plummet of the pound as investors starting to sell the pound resulted in remaining investors getting more anxious and ultimately also selling their investments. This has caused an excess in supply of the pound as investors rapidly transfer to other more stable currencies such as the dollar and overall led to the depreciation of the pound. Furthermore, some economics argue that since the transactions on Monday 26th occurred close to midnight UTC, there may have been a lack of liquidity for such large transactions due to not many sales being processed so late into the night. This could explain the initial large dip in the pound, hitting its lowest, and then slowly recovering to a more accurate value or around $1.08.

What are the impacts?

The impacts are essentially a boost in cost push inflationary pressure due to foreign goods and services becoming more expensive relative to the pound. For example, if you wanted to import a good from the US which is valued at $1, excluding shipping costs it would have previously been £0.88 on September 20th but after the pound depreciated on September 26th, the same $1 good would cost £0.96. This would magnify the cost-of-living crisis which the UK is currently experiencing as consumers and firms would have to pay more to import goods and importing firms may also decide to transfer these higher costs onto consumers. In 2020, the UK imported 46% of the food it consumed, according to the gov website, which indicates how reliant the UK is on imports and implies the major effect a weakened pound will cause in terms of boosting inflation. Furthermore, it may ultimately reduce the quality of life of UK travellers as holidays would become more expensive due to the pound not being able to purchase the same value of items abroad. This can be significant especially as we come close to the Christmas holidays where many families decide to travel during this period.

Are there any positives?

Although the negatives of inflation massively outweigh any positives, there are still some benefits from a lower exchange rate. The most obvious is a fall in the prices of exports compared to other countries. This could help improve the governments Balance of Payments, which is nearly at a £34 million pound deficit in Q2 2022, through encouraging exports and reducing the number of imports into the UK. It could also promote greater globalisation and improve UK trade relations with other countries in the short term. However, I would argue that focusing on the trade deficit is trivial when considering the extent of inflation and the effects it will have on UK households. The UK has been undergoing a trade deficit since 1998 and most recently was 4.5% of nominal GDP in Quarter 2 2022 which suggests how insignificant a trade surplus, or reducing the trade deficit, is in achieving economic growth in the UK.

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