'Theresa May’s Brexit speech spurred a sterling recovery – but don’t get too excited'
By Professor Keith Pilbeam, Department of Economics
The pound reacted positively to Theresa May’s Brexit speech, but don’t let this give you the impression that it is good news for the UK economy. The bounce from around US$1.2150 to around $1.2380 at 5pm UK time on Tuesday is probably no more than what is known as a short covering phenomenon. This is where investors who bet against a currency start to cover their positions to limit their losses when the currency appreciates in in the short run.
So: in the days building up to the speech, there were numerous leaks from May’s speech, suggesting she would outline that a hard Brexit was on the cards. This likely led to expectations of a large depreciation in sterling and large bets to that effect.
By opting out of the single market and the customs union... the UK maximises its losses from both trade in services and trade in goods.
The problem is that when a number of investors speculate against a currency then, on occasion, it can be very profitable for others to bet the other way – and profit if it then appreciates in value. If those betting the other way do so in sufficient numbers and sterling starts to appreciate, then those betting on a fall in sterling will find they start losing money on their positions. Many will then conduct what is known as reversing trades, such as buying sterling forward and futures contracts to limit their losses. This is short covering and these purchases cause sterling to appreciate even more. Typically, it takes a day or two to work its way out of the market.
Another factor that may well have driven sterling higher, which was not foreseen by the markets, was May’s commitment to get the final deal with the European Union to be put to the British houses of parliament for approval. Getting such approval may well require a softer version of Brexit than she outlined in her speech and may even raise the possibility of a second referendum if parliamentarians reject the deal she brings before them.
However, a natural question to ask is whether her speech will be good or bad for sterling in the longer-term? Here I believe there will be a period of further sterling weakness. There are three key ways that I see Theresa May’s Brexit plan hitting the UK economy and, with it, the value of sterling. The first is from reduced trade, the second from reduced investment (at home and from overseas) and the third from reduced immigration.
1. Reduced trade
By opting out of the single market and the customs union (to be free to do trade deals with other countries) the UK maximises its losses from both trade in services and trade in goods. Opting out of the single market ensures that the UK’s services industries – particularly financial services – will lose their passporting rights to sell financial services into the EU.
Opting out of the customs union means that the UK will face potential tariffs from the EU and potentially have to impose tariffs on EU products. This could mean extensive border checks and an impact on supply chains – upon which much of manufacturing is based these days.
2. Reduced investment
By announcing early on in the negotiation process that she is opting for a hard Brexit Theresa May has sent an early signal to foreign investors to avoid the UK economy, as it will most likely have only a very basic WTO-type trading arrangement with its biggest export market, the EU, which currently accounts for over 44% of UK exports.
UK investment in large part requires a long-term guaranteed access to the EU market and May has signalled that this access will be put at risk as she prioritises restricting EU labour movement and ending the jurisdiction of the European Court of Justice. This will hit business confidence and with it investment. Furthermore, investment in the UK has to a large extent depended on having access to skilled migrants from the EU which she is proposing to heavily restrict.
3. Reduced immigration
The UK economy has become reliant on importing both skilled and unskilled labour from the rest of the EU. The net inflows of labour have helped in many sectors of the UK economy – in producing its financial and non-financial services, in the construction industry, manufacturing and in its healthcare sector.
Do not fall for the argument that this has been at the expense of jobs for UK workers. The increased productivity and job creation has been a boost to the UK economy, creating extra aggregate demand and extra taxes for the UK government, enabling it to improve UK infrastructure. This, in turn, stimulates investment and growth.
These three channels of the economy – trade, investment and the migration of labour – have in the past reinforced one another in a virtuous circle. Theresa May’s speech and Brexit plan threaten to create a vicious circle whereby reduced trade, investment and labour flows will combine to undermine the dynamism of the UK economy. This will hit jobs and economic growth, cause a rise in inflation, damage business and consumer confidence, and lower the living standards of tens of millions of UK citizens. None of this is likely to be good for sterling over the longer term.