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5.12.19 12 OPINION 29.9.2022 Jean-Philippe Serbera Jean-Philippe Serbera is Senior Lecturer in Banking And Financial Markets, Sheffield Hallam University Sterling hits all-time low: two things can turn this around but neither is straightforward W hile most people in the UK were still in bed in the early hours of Monday morning, the pound dived. It fell over 4% during Asia trading to reach its lowest ever lev- el against the dollar of US$1.035, while also hitting €1.079 against the euro. is was an exceptional fall, and continues its 3% decline against the US dollar on Friday in response to the hey borrow- ing and tax-cutting in Chancellor Kwasi Kwarteng's mini-budget. In parallel, traders have been dump- ing British government bonds, which is driving up long-term interest rates or yields. e yield on ten-year bonds, which heavily influences mortgage rates and other bank lending, is now above 4% for the first time since its highs fol- lowing the 2007-09 financial crisis. e pound rebounded back above US$1.08 in the hours after the Euro- pean markets opened, while ten-year bond yields have also eased a little. It is possible that the pound crash dur- ing the Asia session was over-extended because trading volumes in the Brit- ish currency are lower, which makes it easier for smaller amounts of money to make a bigger impact on the market. It is not uncommon for lows to be made in early Asia trading, as has been the case in previous currency crashes. On the other hand, many analysts think the pound reaching parity with the US dollar is increasingly likely. So where is all this heading and what will the consequences be? The mini-budget gamble e pound has already been weak- ening for over a year. is is partly be- cause the US dollar has been getting stronger as the US Federal Reserve has raised interest rates and reduced the supply of dollars to try and get inflation under control, and partly because the UK with its exposure to high gas pric- es and post-Brexit challenges does not look like a great prospect for economic growth. e new Truss government's econom- ic and fiscal policies have made the mar- ket even more uneasy. ey are based on a combination of energy subsidies and huge tax giveaways – particularly to high-income households and home- owners – which will increase annual borrowing by more than £100 billion. e tax-cutting, which covers £45 bil- lion of that increase, is a shift away from the direct transfers of money from gov- ernments to households and businesses that have been used to help maintain consumption since 2008 in the UK and many other countries. e benefits of tax-cutting in stimulating the economy are more delayed, which makes them more uncertain than direct handouts. In a situation where there is arguably a need for immediate action to support consumption because people's purchas- ing power is being eroded by rising in- flation, direct cash transfers would have been faster acting. Tax cuts may not even work here. Peo- ple in the UK may well see the negative reaction from the markets and become more pessimistic about the prospects for the economy. If so, they are likely to spend less, which would weaken growth as op- posed to increasing it in the way that the government is hoping for. e gov- ernment deficit – the gap between how much it spends compared to how much it brings in – would then increase and the tax cuts would be counterproduc- tive. Either way, the weaker pound is go- ing to further exacerbate UK inflation by making imports more expensive. At the same time, the rise in bond yields will potentially damage growth by in- creasing lending costs and making con- sumers feel poorer. It will also make the extra government borrowing in the mini-budget even more expensive than it was going to be already. All of this is likely to put further pressure on the public finances. is is all a reminder that politically motivated economic policy does not sit well with the markets. With the gov- ernment stimulating while the Bank of England is tightening monetary policy by raising rates, they are also acting as two opposing forces when it would be better for them to coordinate with one another. What a turnaround looks like It is nevertheless possible that the pound is now steadying amid specula- tion that the Bank of England may in- tervene with a rate rise to support the currency. is would echo the Japanese central bank's recent intervention to support the yen, which is also in a his- toric decline against the US dollar. Yet if the Bank of England does raise headline rates, possibly by 0.5 percent- age points or more, this would have a detrimental effect on business financ- ing and economic activity by further increasing the likelihood of higher rates on mortgages and business loans. is might completely negate the govern- ment's attempts to support the econo- my by cutting stamp duty and revers- ing the planned corporation tax hike – again undermining the growth plan. e bigger question is what happens to US inflation. If it were to fall thanks to a drop in the cost of energy imports and an improved global supply chain, the Federal Reserve may pivot on mon- etary policy. is would entail a pause on recent interest-rate increases or even the start of a reversal, which would take pressure off currencies such as the pound and help rescue the UK econo- my. Only then would the supply-side measures in the mini-budget geared towards helping businesses with lower corporation tax, simpler planning and low-tax investment zones bear fruit. Even then, the government would have to hope that consumer and business sentiment had not deteriorated too much in the meantime. at all amounts to an extraordinarily risky gamble – if it doesn't pay off, ex- pect more trouble ahead. Liz Truss' £220 billion plan for growth melds the biggest tax giveaway in half a century with Thatcherite deregulation

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