The pound is set to fall hard next year, say two big US investment banks. And this time, they might just be right. Goldman Sachs says the pound is 13% over-valued on a trade-weighted basis. Lehman Brothers is gloomier still, expecting sterling to fall to $1.82 next year, before sinking to $1.68 by Christmas 2008.
Currencies: why sterling is heading for a fall
The reasons are simple. Just like America, Britain is running a huge trade gap with the rest of the world – the largest in western Europe. And just like America, Britain has vast government debt. Officially, public sector net debt stands at £486.7bn. That’s equal to nearly 38% of annual GDP. But add the state’s ‘off balance sheet’ debt – such as pension promises to state-paid employees – and the total shoots nearly three times higher. The Centre for Policy Studies says this would put the deficit at 103% of GDP – more than £53,000 per household.
Then there’s consumer debt – only here, Britain is way ahead of the States. Total consumer liabilities run to a year’s worth of GDP. The British now owe £1trillion in housing debt, much of it in interest-only loans. Add in average unsecured debt per household of £8,592, plus personal bankruptcies doubling to an all-time record since 2004, and “the surprise is that the pound has been so strong”, says Lehman Brothers. “Current account deficits matter over time, and we’re worried that Britain’s [trade] deficit could widen to 4% of GDP in 2008.”
But none of this is new. Other US investment banks have called the pound lower before and got it wrong. And all the while, the pound has grown weaker on the fundamentals. Britain’s broad money supply has exploded 25% since the start of 2005. That’s the fastest by far of the G7 economies, and nearly twice the rate of world money growth. Worse still, in early April, dollar interest rates overtook pound rates for the first time since 2001. A research note from HSBC showed that, during the previous 30 years, the GBP/USD pairing – known as ‘cable’ by traders – had lost 12% per year on average whenever dollar rates were higher. Yet this time the pound shot higher against the greenback. Why? Because the pound has become the ‘anti-dollar’ of choice for the world’s central bankers. The Bank for International Settlements (BIS) reports that the pound accounts for 12% of all foreign reserves held by governments worldwide. It is now the world’s third reserve currency, second only to the dollar and euro.
Currencies: where will central bankers turn next?
What do central bankers love about sterling? Quite simply, it isn’t the dollar or euro. But what if the dollar keeps falling, and sterling falls too? Where will central banks turn next as they try to spread their currency risk from one fiat money to another? All central bankers now share this ‘non-dollar’ headache. The BIS puts total worldwide currency reserves at $4.8trillion, a full 11% of world GDP. When the pound hits the skids – which even Wall Street knows it must – the stampede out of sterling will send the next-best-thing soaring. But what will that be? Japanese inter-bank lending pays less than 0.4% today. The euro yields two percentage points less than the dollar. The Swiss franc pays even less, and the dollar itself looks ugly on any analysis.
How about the commodity currencies, Korean won, or the Russian rouble? BIS data suggest that central banks have indeed increased holdings of non-major currencies in recent years. But here’s the snag. There aren’t enough non-major bonds to go round. The dollar, euro, yen, sterling and Swiss franc account for 83% of the world’s total debt issuance. The big central banks can’t seriously raise their non-major holdings without freaking the market, most of all at the long-dated end where supply would be tightest.
Currencies: why gold may find favour
Of course, there’s always gold. It pays no interest in a world always searching for yield, and so now accounts for just 0.5% of all government reserves by value. But now the five big currencies all look as bad as each other, then who knows? Gold might just find favour – especially in Asia. “It is unfortunate how much [India] has lost by… holding on to the antiquated belief that gold transactions in the market by the Reserve Bank of India are bad, while frequent transactions in USD, euro, yen and sterling are good,” said former RBI deputy governor SS Tarapore late in November. “Gold is unique, in the sense it is both a commodity and a store of value… More importantly, gold invariably moves inversely with the US dollar and also rises in value when international inflation gathers momentum.” Central bankers in gold buying shock? You read it here first.
Adrian Ash is city editor for The Daily Reckoning and head of research at BullionVault.com.