Economics: Sterling prepares for a holiday in the sun
Sunday 11 August 1996
Tourism differs from other industries in two main ways. First, it is most sensitive to shifts in exchange rates. In other industries there is a lag, for it takes a while to negotiate new contracts, find alternative suppliers, build new factories in other countries. But the decision to holiday in a different location because it is cheaper can be acted on in a few weeks. Second, people are directly aware of the exchange rate in that much of the payment is made in another currency: you see that you can buy a three-course meal in Montreal for the same price as two cups of coffee in Nice. If you buy a foreign product someone else has made the currency transaction and put the price into sterling.
For most of the post-war period, and rapidly after the 1967 devaluation of sterling, Britons have learned to live with a fairly weak currency: not as bad as say the Italian lira, but worse than the other main currencies in the world, in particular the dollar, the mark and the yen. Each time we go abroad, we tend to get fewer foreign notes, but have been compensated because inflation elsewhere has been slightly lower than in the UK. This long decline of sterling against the dollar and the mark from 1962 onwards is shown in the left-hand chart.
Of course in real terms the value of the pound has been more constant. More of that in a moment. But focus first on the nominal exchange rate - and consider the possibility that we might soon see the pound regain some of its lost value.
This might seem an unlikely possibility. We are clearly heading into a consumption-led mini-boom; the Bank of England last week warned that interest rates would have to go up if inflation were not to rise at some stage in the future; and there is the prospect of a Labour government, which is associated with higher inflation and weaker currency.
But now Mark Cliffe, the chief economist at HSBC Markets, the investment banking side of the Hongkong & Shanghai Banking Corporation, has just come up with a novel idea: that the election of a Labour government next year could lead to a strong pound.
When people cut across conventional wisdom they deserve to be taken seriously. At the moment a Labour victory is priced into the markets: share prices are lower than they would otherwise be, with London failing to keep up with the rise on Wall Street, and the pound is somewhat below its purchasing power parity. So if this view is wrong, there is money to be made in backing British equities and sterling.
The HSBC argument runs like this. New Labour is different from the tax- and-spend, anti-EU party of the past. It will inherit an economy in good shape and an undervalued pound. It has learnt that international financial markets impose swift penalties on governments that are reckless. Its pro- EMU stance could lead to a rerating of sterling and sterling securities. If the markets reckon that Labour will put the pound into EMU, they will bid up its value to its likely entry point, for the Germans and French would not allow us to go in at our present undervalued exchange rate.
The result? Far from there being a traditional sterling crisis, the Labour government might find sterling was being pushed too high and have to cut rates to hold it down. The HSBC projection for the pound by the end of next year is $1.75 against the dollar and the DM2.45-2.60 range against the German mark. It is an interesting idea and it may prove right, even without the early entry to EMU. But there are weak points in the argument that need to be noted.
The most obvious weakness - that the instincts of Labour to tax, spend and not worry about inflation are possibly just too strong - is perhaps less of a concern because of the discipline that the markets will impose. There is surely more of a worry that if Labour gets in we will have an inexperienced government. Forget about not having Cabinet experience: we will have a Prime Minister and a Chancellor who were not even in Parliament when Labour was last in power. There are bound to be mistakes of economic policy and these mistakes will probably undermine the pound.
However, the two mistakes you can be sure these people will not make will be those that the Tories made over sterling. One was in the late 1980s when the pound was shadowing the German mark and Nigel Lawson cut interest rates to stop the pound going too high. That exacerbated the boom.
The other mistake, in the early 1990s, was tying sterling into the ERM at the wrong rate. A Labour government might try and take Britain into EMU, but it would surely not allow itself to be pushed by the Germans and French into a less competitive exchange rate.
You can see the advantage that British exporters have enjoyed vis-a-vis France and Germany by looking at the right-hand chart. UK unit labour costs improved against other European countries between the early 1980s and 1992. Then came the breakup of the ERM. While our labour costs then deteriorated against the European devaluers, (countries like Italy, Spain and the Nordics), they continued to improve against the revaluers (principally the Benelux countries, Germany and France).
Nevertheless, if the full "New Labour's sterling rally" thesis does not stand up, it is possible to believe that the long decline of the pound may be over and may reverse itself over the next few years. In a way that is a much more radical notion than the one that Labour could be good for the pound.
There are two main reasons to believe that this might happen. The first is that currency movements are likely to be much smaller in the next 30 years than they have been in the past because inflation, at least in the developed world, is going to be lower. The reasons for that include the shift of manufacturing to lower-wage economies in east Asia, which will exert a downward pressure on prices here, the power of the international markets noted above, and the ageing of the population who will hardly vote to see their savings whittled away by inflation. If inflation is low, even non-existent, then there is much less need for currency realignments.
That would suggest the decline of sterling may be over, but it would not account for a recovery. To argue for that is to argue that countries with a competitive advantage may see their currencies appreciate and that Britain has just such a competitive advantage. There are several reasons why it might. These include: less unfavourable demography than any other large European country; strength in areas (like the entertainment business and financial services) that do not seem to face competition from east Asia; relatively early adjustments in the pensions and benefits system; and what is clearly an attractive manufacturing environment for foreign investors. The jury is still out on the overall competitiveness of the UK, but at least there is an argument to be made.
So, if HSBC is right, foreign hols next summer will enjoy the benefit of a more favourable exchange rate; but if this wider case for a recovery in sterling is right, our foreign hols for the next generation will benefit too.
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