What Does the UK Election Mean for the British Pound?

Pound is whether or not the first coalition government in the UK since World War Two can develop and implement policy effectively. Notwithstanding the sharp declines in Sterling that have taken place in recent days as a result of the overall rise in market risk aversion, the Pound appears attractively valued from a trade-weighted perspective. However, there are crucial obstacles that still need to be surmounted if the Pound is to see sustained gains.

Were do we stand now?
After an extended period of decline, the announcement of the formation of a coalition government between the Conservative party and the Liberal Democrats prompted a short-lived rally in Sterling. The relief rally was triggered in part by the resolution of the uncertainty over which political party would govern the UK. The gains were quickly reversed however, as concerns about policy implementation again moved into focus. Clearly one of the top priorities for the newly formed coalition government – besides its own survival – will be to quickly implement measures to cut the budget deficit. According to the UK Office of National Statistics (ONS), the UK budget deficit was 11.4% of GDP at end-20091 (see Figure 1). The previous Labour government aimed to have the deficit pared back to just over 4% by 2014/15. The current Coalition government has announced that it will accelerate the prior deficit reduction program timetable. While policy details of any significance are scant at this stage, it appears the improvement in the government’s finances will be mostly made via cuts to spending rather than increases in taxation. While the Coalition has committed to making spending cuts in the order of £6bn within the current financial year, increased taxation will also play a role, possibly including an increase in non-business capital gains tax to around 40% from current levels of 18%.

Fiscal Consolidation
It is clear that both Cameron and Clegg are cognisant of the dangers in not dealing decisively with the budget deficit and the announcement of the preparation of an emergency budget prior to the end of June.

Non-frontline govt services cuts – £6bn in 2010/11 No increase in NI contributions Non-business capital gains tax could rise to 40% Raise personal tax allowance to £10,000 over longer-term Reduce spending on tax credits for high income earners The budget’s high priority indicates a strong commitment to fiscal prudence and should be a supportive influence on Sterling. The formation of an independent Office of Budget Responsibility appears to strengthen that commitment. However, the market remains hesitant to embrace the Pound with still significant uncertainty surrounding policy detail and implementation.
The key to restoring economic prosperity (and fiscal credibility) relies on balancing the timely withdrawal of government stimulus measures, with a rebound in private demand and economic growth. Should more strict austerity measures in the UK suppress economic activity more than currently anticipated, the longer-term prognosis for Sterling appears more negative, as debt level trajectory could approach similar paths to those sustained during the financial crisis (see Figure 2).
Effective Policy is Key
At the time of the last (elected) hung parliament in February 1974, the UK economy was in a similarly poor state with a worsening fiscal position. The minority government at the time lasted only seven months before another election was called. A similar fate could await the current Coalition, should effective decision-making be hampered by the significant ideological differences between the Tories and Liberal Democrats. Credibility is critical for the new government. While the government appears ready to tackle the issue of the budget deficit head on, it could be other issues still risk derailing the Tory-Liberal Democrat alliance. If the coalition partners are unable to collaborate to effectively implement a range of policies, it is likely not only to erode confidence in the government but in its ability to mange the UK economy more broadly. So far, the initial commitments from the Coalition are positive in tackling spending rather than weighing down the private sectorwith additional taxation. And the Governor of the Bank of England has also hailed the proposed measures as ‘strong and powerful’.

Attractive Valuation
On a trade-weighted basis the British Pound appears to be attractively priced. The UK REER is coming off the lowest levels experienced in around 15 years, and is currently hovering at levels last seen in 1996 (with the exception of the lows seen during the financial crisis) (see Figure 3). While risks to a Sterling appreciation remain, the UK Real Effective Exchange Rate (REER)2 is trading at a discount of around 15% below its longerterm average, suggesting that the market has more than discounted the impact of the financial crisis on the UK’s trade and growth prospects. While the Eurozone economy experiences similarly difficult economic conditions, the UK REER is hovering 17% below the Euro REER.
Conclusion
The British Pound is likely to experience difficult trading conditions in the near-term. Sterling could experience some appreciation in coming months if the newly formed Coalition gains political credibility. However, investors remain jittery and the post-election optimism for Sterling could be short-lived should the nervousness over the European sovereign debt crisis escalate into another market panic. The longer-term outlook for the currency appears somewhat negative given that underlying
activity is likely to remain subdued as fiscal retrenchment takes hold.

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1) The HM Treasury estimate for the budget deficit for the period 2009/10 was 12.2%. Eurostat reported an 11.5% budget deficit for the UK for 2009.
2) The REER is a trade-weighted real effective exchange rate for a country and is published by the IMF. The UK’s REER, for example, is calculated as a weighted average of a basket of the currency rates of the UK’s main trading partners.