Why does the value of the pound fall?
BY Chris Menon
5th May 2023 Managing your Money
As a recession continues to loom large, we break down what's behind the fall in the value of the pound, and weigh up the good and bad impacts it could have
There is currently no official, fixed exchange rate for the pound sterling as it fluctuates according to what the foreign exchange market will pay for it. Over the past year it has depreciated against both the euro and the dollar (as of April 25, 2023, it has fallen 4.9% against the euro and 2.4% against the dollar).
Nevertheless, it has gyrated widely over that period. For example, back in September 2022 it fell to its lowest level against the US dollar since decimalisation in 1971, as the foreign exchange market reacted unfavourably to the UK’s biggest tax cuts in 50 years under Conservative Prime Minister Liz Truss, dropping to US $1.03.
"Back in September 2022, the pound fell to its lowest level against the US dollar since decimalisation in 1971"
Even in a system where the exchange rate is fixed, a currency can still be “devalued” if it seems the best course of action. From 1944 to 1972, the UK fixed sterling’s exchange rate against the US dollar.
Still, fixed or not, there have been several occasions, during economic crises, when the pound sterling has lost value.
- In 1949 Clement Attlee, the Labour Prime Minister, devalued the pound by 30%.
- In 1967 another Labour Prime Minister, Harold Wilson, devalued the pound by 14%.
- In 1976, now on a floating exchange rate, sterling depreciated by some 30%, forcing James Callaghan’s Labour government to borrow US $3.9 billion from the International Monetary Fund to stabilise the value of the pound.
- In 1990 we entered the European Exchange Rate Mechanism, where currencies were not allowed to shift by more than 6% from a target rate. But in September 1992, John Major’s Conservative government was forced to pull out—after which sterling depreciated by 15%.
In September, the British pound fell to its lowest value against the US dollar since decimalisation
Influencing factors in the fall in the value of the pound
The value of the pound sterling can fluctuate due to various economic and political factors. Some of the factors that can lead to a decline in the value of the pound include:
- Interest rates: If the Bank of England lowers interest rates, it can reduce the demand for sterling and debt denominated in pounds sterling, as investors may seek higher yields elsewhere.
- Inflation: Over time inflation erodes the purchasing power of the pound by reducing the amount of goods or services you can purchase with your money. Economist Lukasz Krebel from the New Economics Foundation calculates that, using figures based on the Consumer Price Inflation Index, from 1970 to 2022 the pound lost approximately 93.5% of its value.
- Political instability: Uncertainty surrounding political events, like Brexit or a change in government, can lead to a decline in the value of the pound. For instance, if at the next General Election there is a hung Parliament, with no political party having an overall majority, the uncertainty could see the value of the pound sterling fall.
- Economic performance: If the UK economy is performing poorly and goes into recession, it can lead to a decrease in demand for the pound
- International trade: If the UK has a widening trade deficit or experiences a decrease in demand for its exports, it can lead to a decline in the value of the pound.
- Speculation: Speculators betting against the pound can also contribute to its depreciation. The most famous example of this was in 1992 when George Soros sold billions of pounds during the days preceding the devaluation of the British pound and its withdrawal from the European Exchange Rate Mechanism on “Black Wednesday”, September 16, 1992.
Overall, the value of a currency like the pound is affected by a complex interplay of factors, both domestic and international.
But what are the effects of a fall in the value of the pound against other currencies?
Positive effects
The fall in the value of the pound could make British exports cheaper and more attractive to international buyers
A fall in sterling should make the UK more attractive to tourists, boosting our leisure sector. In the short term it also makes our exports cheaper, which should make them more competitive internationally and boost overall export sales.
"A fall in sterling should make the UK more attractive to tourists, boosting our leisure sector"
However, if there is a global recession, demand will be down overall.
As we export more and cut back on imports (which have become relatively more expensive) it should help the country reduce its balance of payments deficit—as the UK has been living beyond its means.
Negative effects
A fall in the pound affects manufacturing because imported raw materials become more expensive. If you take an overseas holiday you’ll also notice that the pound sterling buys less.
"If you take an overseas holiday you’ll also notice that the pound sterling buys less"
The main worry is that, if sterling’s value slides too far, there could be a “run on the pound”, where the financial markets lose so much confidence that investors rush to sell sterling and sterling-denominated debt, such as UK government bonds, known as “gilts”, plunging its value lower.
If that happens it would be necessary to raise interest rates to persuade investors to buy debt from the UK government.
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