Why is the UK pound crashing?

Britain at risk.

Sulaiman Daud | September 29, 2022, 12:44 PM

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The pound sterling, the currency of the United Kingdom, is plummeting.

What happened?

It recently hit a historic low of 1 pound to S$1.59, slipping further to S$1.48 on Sep. 26, before rallying a little to about S$1.55 on Sep. 29.

If you're a millennial, you probably have memories of a pound going for as much as S$3, so the recent flash crash was a bit of a surprise.

Why did this happen?

The most immediate cause was a "mini-budget" announced by new UK Chancellor Kwasi Kwarteng (the equivalent of a finance minister).

Kwarteng's speech took place after the Members of Parliament resumed government business following the recent death of Queen Elizabeth II.

It was his first major policy announcement after his appointment by the newly-minted UK prime minister, Liz Truss.

Bloomberg and The Guardian highlighted the following points from Kwarteng's budget:

  • Scrapping the top rate of 45 per cent income tax for those making more than £150,000 a year.
  • A cut in basic income tax rate from 20 to 19 per cent is brought forward to April 2023.
  • Reducing stamp duty (tax) on property transactions.
  • Scrapping the cap on bonuses for bankers.
  • Cancelling a planned hike in the National Insurance tax.
  • Cancelling a planned hike in corporate income tax.

You can watch it below:

What's so bad about the Kwarteng budget? Sounds pretty good.

Kwarteng's plans will have to be paid for, but he did not announce any major tax hikes to fund his proposals.

The Treasury also committed to existing public expenditure totals which are set until 2024/2025.

Therefore, the UK government will instead borrow the money they need for Kwarteng's proposals. This amounts to "tens of billions of pounds", according to the BBC.

And the UK is in a particularly bad position to start borrowing huge amounts of money.

Interest rates charged for government borrowing rose as high as 4 per cent, as compared to 1.8 per cent a couple of months ago.

What's troubling the UK economy?

Almost every country today is battling high inflation and prices, including Singapore.

High inflation rates are partly driven by the Covid-19 pandemic and its aftermath.

On the demand side, consumers around the globe want to buy more things after two years of shortages. How many of you still can't walk into a shop and buy a PS5?

On the supply side, labour shortages due to Covid infections and people in supply chains (like dockworkers unloading cargo) losing their jobs during the pandemic, and not returning for various reasons, has hit production hard.

The Russian invasion of Ukraine has also driven up the prices of commodities like grain, as Ukraine is a major producer.

And China's ongoing zero-Covid policy has slowed down production in the world's biggest manufacturer.

But how does that result in a weak pound?

There are many different reasons that may result in currency depreciation, such as political instability or weak economic fundamentals.

Kwarteng's budget does not appear to have instilled confidence among investors and outside observers that the UK would be able to take on the additional debt burden.

Paul Johnson, the Director of the Institute of Fiscal Studies, a UK think tank, said to the BBC, "The plan seems to be to borrow large sums at increasingly expensive rates, put government debt on an unsustainable rising path, and hope that we get better growth."

Currency depreciation may lead to a downward spiral as foreign investors rush to pull their money out of the country, driving the currency's value down even further.

Economists are also concerned that Kwarteng's burst of fiscal stimulus (as more UK citizens will have more money in their pockets) will cause them to spend more, drive up demand, and worsen inflation even more.

What has the reaction been like?

Former U.S. Treasury Secretary Larry Summers (equivalent to Singapore's finance minister), called Kwarteng's tax cuts "utterly irresponsible". He specifically highlighted the UK's debt sustainability risk.

According to The Washington Post, investors are also "concerned that the new budget will put the country’s debt on an unsustainable path".

It pointed out that government coffers had been stretched due to emergency spending to handle Covid, as well as "soaring energy prices" after the UK sanctioned Russian oil and gas for invading Ukraine.

This came after what The Washington Post described as "many years of low productivity" in the UK as compared to its competitors in Europe.

Even the International Monetary Fund, the global lender of last resort, openly criticised the budget, something considered unusual. It said Kwarteng's proposals would likely increase inequality and add to price surges.

Credit rating agency Moody's warned that the proposals could "permanently weaken" the UK's debt affordability.

On the other hand, some supported the Kwarteng budget, like Allister Heath of the Telegraph.

What can the UK government do about it?

UK Prime Minister Truss can reverse the mini-budget, but at least one report has indicated that she is sticking by her chancellor despite the currency shock.

Leader of the Opposition Sir Keir Starmer has called on Truss to recall Parliament and abandon her proposals.

It remains to be seen if she will do so.

What does this mean for me, a Singaporean?

Assuming the UK's situation gets worse, there could be a knock-on effect on global markets, leading to more volatility and uncertainty, according to Reuters.

As an open economy and a financial hub, Singapore is at risk if other countries slide into recession.

Writing for CNAOCBC's Chief Economist Selena Ling said back in July that trade-related sectors and Singapore's exports may take a hit if the financial situation in Europe gets worse.

The Monetary Authority of Singapore said in July that trade-related sectors will likely be affected in the second half of this year.

However, it added that domestic-oriented and travel-related sectors should continue their recovery and support economic expansion. Singapore’s full-year growth should still come in around the 3 per cent to 5 per cent forecast range.

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Top image from Mawd Elen Facebook.