Most of us are getting Brexit fatigue. We will soon be talking about some other global economic trouble spot as work on the UK-EU separation goes on.
But before we put Europe aside, there is one consistent question we are getting on the FX desk:
- Why has the euro proven relatively resilient while the value of the British pound has plummeted?
- Since the Brexit vote, the euro is down about 3 percent while the British pound is off by about 13 percent.
It is a good question. Evidence suggests that the UK pulling out of the European Union will cause a fairly seismic-sized blow to the European continent’s economy as well as to the UK’s. This week four Italian banks came under intense scrutiny for their solvency amid concerns that the financial stress could be a contagion to other economies.
The answer largely comes from a mundane analysis of macroeconomics – in particular the current account balances (essentially the trade balance of imports vs exports) of Europe and the UK.
The UK is running a current account deficit of 7 percent of GDP – a pretty high number by major economy standards. That will naturally reduce due to the cheap British pound since imports get more expensive while exports get cheaper.
However, it will take a while for exporters to ramp up production to take advantage of a cheap currency, so the UK needs to rely on foreign direct investment into the country if it wants a stable exchange rate.
That is very difficult in the current environment. Not only are things very unsettled politically in Britain, but we continue to see government bonds yields get even lower. There is just not much good reason to expect a lot of money to come into the UK these days.
By contrast, the Eurozone has a trade surplus of about 4 percent of GDP. They have no need to require foreign investment into the Eurozone and do not expect capital flows out of their economy. In times of trouble, a lot of European money will stay home, as it does in similar situations.
My View: Even in times of high emotion and stress in the geopolitical environment, fundamentals matter. The global financial system still responds primarily to money moving from one spot to another. If you are trying to navigate this economic maze, you must keep this in mind.
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