In my previous commentary here, I made the point that what really matters in the economic and financial context of the coronavirus crisis isn’t what happens to stock markets, but the imperative need to mitigate the consequences of the inevitable slump in companies’ and households’ cash flows.
After much ammunition had been fired at the wrong target by the Fed and the other central banks, governments have stepped in, recognising the need to ensure that breaks in income continuity don’t take down businesses and families.
With one misconception scotched, though, another has arrived to take its place. This one concerns the slump in the value of the pound which, since the crisis began, has fallen by 11 per cent against both the dollar and the euro.
This slide is serious, particularly at a time when circumstances are forcing the authorities, in Britain and around the world, into huge (and, let’s face it, risky) monetary largesse, just to keep the economy functioning.
If a weakening currency is one problem, the way in which this event is being presented is another. Some parts of the media, which really ought to know better, are painting this as some kind of market “verdict” on the supposed inadequacies of the British government’s handling of the virus epidemic (whilst some contributors to on-line debates are even trying to link it with “Brexit”). There also seems to be some conflation of this Sterling issue with some seemingly-strange falls in the values of ‘safe haven’ assets, such as gold, and ultra-safe sovereign bonds.
Let’s deal with those “strange” selling trends first. In modern markets, buying “on margin” is a common practice, and what this means is that it’s customary to put up only a small fraction of the sum invested when buying shares, borrowing the balance from a broker.
Unless the buyer has sold within the short duration of the loan, he or she then gets a “margin call”, which is a demand for the outstanding balance. To meet these calls, investors have to sell something – and almost the only investments that can be sold in these chaotic markets are ‘safe-haven’ assets, such as gold, and US Treasuries.
Much of this margin activity is taking place in the United States, which means that investors might have to realise assets elsewhere, in order to buy dollars with which to meet margin calls in America. This affects FX (foreign exchange) rates, but doesn’t form part of any “verdict” on non-dollar currencies such as the pound.
Rather, what’s really happening, behind these “strange” effects, is that investors are trying to gauge the exposure of the various currencies to the world financial system. The best way of assessing exposure is to look at financial assets.
British financial assets, excluding those of the Bank of England, were 1,100 per cent of GDP the last time these were measured (at the end of 2018), far higher than the ratios of the Euro Area (620%), let alone America (460%). Add to this the worldwide flight to the dollar and it’s not hard to see why the pound is under the cosh against the US dollar.
This said, the equivalent weakness of Sterling against the euro makes much less sense. The euro area does have less global financial exposure than Britain, but parts of its banking system are notoriously weak, certainly in Italy, and very probably in Spain, with the latter suffering the results of its post-2008 binge in Latin American investment.
Moreover, some individual euro area countries are dangerously exposed to the global financial system, which tends to correlate the overall strength of the euro with the preparedness of the strongest members (meaning Germany) to support the weakest (which is Ireland). It’s relevant here to note that, even before the crisis began, Spain and Italy, between them, already owed getting on for €1 trillion to Germany through the Target2 clearing system.
With this clarified, we can note that Britain is indeed disadvantaged by the sheer extent of its systemic exposure to global finance. Markets aren’t much interested in governments’ responses to the virus itself (since we know this will end sometime), but are exercised by what this crisis might do to a country’s economy and financial system.
This is where FX markets exert a meaningful influence on the costs-and-risks of policy choices facing ministers. The imperative is that government throws its support behind the banking system, so that banks can act to minimise the danger of failures (and resulting defaults) from businesses and households.
Governments can, and indeed must, find direct as well as indirect, ‘via-the-banks’, ways of providing support, but these plans are only going to work if official and banking processes work together in ways that are as co-ordinated and as seamless as they can possibly be made.
However you look at it, and whatever you choose to call it, this is going to involve the provision, meaning to a large extent the creation, of new money with which to buttress the system. Pouring a lot of new money into the system necessarily carries risks, and a fall in a country’s exchange rate exacerbates these risks, and is an important factor in gauging them.
Mr Sunak will know that he has to keep one eye on the value of Sterling even as he endeavours to provide financial support to the economy. In this context, Mark Carney’s 2016 remark about the dangers of relying on “the kindness of strangers” takes on a new meaning and significance.
Ultimately, the equation facing the Treasury has at least three moving parts. If the first is the quantity of financial support required, and the second is the duration over which this needs to be sustained, the third is the extent of risk which these actions pose to the perceived resilience of the currency.
These are tough calls, particularly at a time when ‘scoping’ the potential extent and the severity of the financial risk is extremely difficult. The government needs, and presumably has, a range of contingency measures in place to counter worst-case scenarios, not the least of which is a serious devaluation of the pound.