December 29, 2014

The Sterling Crisis of 2015?

By all accounts, the UK general election to be held in May 2015 is too close to call. On May 8th the nation is expected to wake up to another coalition government, quite possibly composed of three or more Parties. While the composition of the new government cannot yet be foreseen, it seems most likely that either the Conservative Party or the Labour Party will be the senior partner in whatever coalition government emerges from post-election negotiations. While for political pundits this election may well be one of the most interesting in many years, the economic risks are daunting; two very dark economic clouds are on the horizon. The first is the issue of government debt reduction, and the second is the question of UK membership in the EU.

A left-wing coalition led by Labour would put aside for now the question of UK membership of the EU, as Labour, Liberal Democrats, Scottish National Party, and the Green parties are all pro-EU, but they are expected to commit to a much slower pace of deficit reduction than is proposed by the Conservatives. Slower spending cuts, alongside any increased borrowing and higher taxes that they may propose to finance government efforts to stimulate economic growth, may lead to a significant risk that markets may well begin to lose confidence in the government’s commitment or ability to address its growing debt problem, with potentially serious repercussions for the value of Sterling.

If the Conservatives are the senior partner in a more right wing coalition their deficit reduction plans may prove politically difficult to implement, leading to politically expedient delays. The Conservative plan to eliminate a £90 billion annual deficit over the course of the next Parliament will seriously affect the well being of a lot of people, and will not happen without a great deal of political opposition. Of similar danger to the deficit problem is the question of UK membership of the EU. Responding to popular disaffection with the EU – amply demonstrated by the rise of UKIP – the UK Prime Minister David Cameron has pledged to hold an in-out referendum on UK membership of the EU by 2017, if he is returned to Office in 2015. This will cause great uncertainty amongst investors as to what the “rules of the game” will be post 2017. Such uncertainty will depress investment in the UK economy, which will further constrain economic growth and exacerbate the political difficulties of meeting deficit reduction targets. Such a reversal of fortunes would again put pressure on the value of Sterling.

Over the past four years, through a combination of luck and contrivance, the current government has enjoyed a fragile recovery from the market crisis in 2007/08. That economic growth has been due almost entirely to an accumulation of household and government debt, supported by historically low interest rates, that has been used largely to maintain high levels of current consumption. While some moderation in the growth rate of the economy should be expected over the coming years, the election in 2015 poses the greatest domestic challenge the economy has faced over the past seven years. Whichever Party holds the senior position in the government after the elections in May 2015, there is a real risk of a Sterling crisis. Such a crisis in confidence in Sterling might be welcomed by exporters, but it would also exacerbate the extremely high current account deficit, increase consumer price inflation, and necessitate an increase in interest rates faster and further than would otherwise be implemented. If this happens, significantly weaker economic performance than is currently foreseen can be expected, including a return to recession.


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