Why the U.K. Government May Need to Crash Its Own Currency

By: Justice Clark Litle

Oct 19, 2020 | Educational

The United Kingdom is headed for a “No Deal Brexit” break-up with the European Union. This assessment is based on harsh statements coming directly from Boris Johnson, the U.K. Prime Minister.

If a “No Deal Brexit” happens, or even just an exceptionally “Hard” Brexit, the result could be a hammer blow for the British economy.

That, in turn, could force the U.K. government to devalue the British pound aggressively, or even crash it, to try and steer the U.K. economy away from disaster.

This creates a trading opportunity, by way of shorting the British pound.

In some ways, the opportunity is reminiscent of 1992, a year when the U.K. was forced to devalue the pound to try and save the British economy.

On Sept. 16, 1992, a single-day collapse in the value of pound sterling was dubbed “Black Wednesday,” with a famous macro hedge fund earning profits of $1 billion in 24 hours.

The 1992 currency crash was widely blamed on “speculators” in the financial press. But in reality, the U.K. government itself was to blame.

The British government had been forced to withdraw the pound from something called the European Exchange Rate Mechanism, or ERM, because the currency was too strong, at that point, for the struggling British economy to handle.

The strength of a currency matters more to some countries than others. An important factor is how much of a nation’s economy is based on exports; that is to say, how much revenue the country earns from goods and services sold to other countries.

The more export-oriented a country is, the more that a too-strong currency is a problem, because a too-strong currency makes exports overly expensive for other countries to purchase.

A weak currency, in contrast, is favored by a country’s export sector, because it makes exports cheaper for overseas customers to buy.

The U.K., as a nation, is heavily export-dependent, with nearly 32% of the British economy powered by exports in 2019. That is a heavy percentage. By comparison, the U.S. economy was only 12% powered by exports in 2019, and China’s economy was just over 18%.

You might not have thought the U.K. was a far bigger exporter than China, in percentage terms relative to its own economy, but it is.

In practical terms, this means a “No Deal Brexit” could be an economic disaster for the U.K. economy.

The European Union, as a giant next-door neighbor comprised of 27 member countries, is Britain’s largest trading partner by far. This is wholly to be expected, as countries typically trade the most with their immediate geographical neighbors.

About 43% of all U.K. exports go to E.U. member countries, and more than 51% of U.K. imports come in from the E.U., according to data from the BBC. If a “No Deal Brexit” goes through, that two-way flow of goods could be thrown into chaos. 

As of this writing, Brexit negotiations are now down to the wire, and Boris Johnson seems to want to smash them (more on that shortly). If no agreement is made, then the U.K. will revert to “No Deal” status as of Jan. 1, 2021.

When trading partners lack a comprehensive agreement, as with Australia and the European Union, their terms of trade are governed under World Trade Organization (WTO) rules.

As part of the E.U., the U.K. had free-flowing trade with all E.U. member countries. Switching to WTO rules would cause all the old agreements to be ripped up as of Jan. 1.

That would not just mean a requirement to renegotiate tariffs, but the need to handle a staggering amount of paperwork on safety rules, customs inspection, and all manner of other legal trade requirements that would expire with a “No Deal” result.

It would also mean the potential renegotiation of dozens, if not hundreds, of individual import and export product agreements, in the absence of the overarching framework that the E.U. relationship provided. 

A No Deal Brexit result could be immensely painful for both the U.K. and E.U. alike as a significant flow of trade, in both directions, screeches to a bureaucratic halt.

But this disruption would likely hurt the U.K. a lot more, because the U.K. is a far smaller entity, whereas the E.U. has an economic output on par with the United States.  

Johnson, the U.K. Prime Minister, is taking such an aggressively hard line in final Brexit talks that E.U. negotiators suspect he is bluffing.

On Oct. 17 per the BBC, U.K. government representatives said talks between the U.K. and E.U. are “over,” and that there was “no point” in continuing discussion. Johnson himself further said the U.K. must consider the “alternative,” by which he meant an Australia-style deal that is really a “No Deal” result.

British exporters are alarmed by all this, as the Financial Times reported last week:

“More than 70 British business groups representing more than 7 m[illion] workers have made a last-ditch attempt to persuade politicians to return to the table next week to strike a trade deal between the EU and UK.

Organisations from across British business in automotive, aviation, chemicals, farming, pharmaceuticals, tech and financial services sectors have united to urge both sides to find a compromise over trade terms.

Bosses were alarmed by Boris Johnson’s move to end talks with EU negotiators on Friday and fear that what they see as a clear need for a deal to protect jobs and investment will be sacrificed for political motives.”

In some ways it is hard to understand the strategy here, because, in taking a ferociously hard line, Johnson seemingly wants the E.U. to bend or compromise in areas where compromise is impossible.

There are certain things the E.U. cannot agree to, under any circumstance, because of the need to preserve a sense of fairness and continuity with the 27 E.U. member states.

If part of your negotiations involve demanding something the other side cannot give, you aren’t really negotiating — unless the thing you actually want is to blow up the talks, or run the risks of doing so until the very last second. 

Either way, and even if a last-minute Brexit deal is agreed to — preserving some form of trade between the E.U. and the U.K, versus the Australia-style, “No Deal” default — it looks like the U.K. economy will be in for some severe turbulence.

The U.K. economy, like many others, has already been hurt by the coronavirus pandemic, with the threat of new restrictions and pandemic-related slowdown once again looming. The disruption of a No Deal Brexit result, with the U.K. crashing out of the E.U. on Jan. 1, could make all of that immeasurably worse, and U.K. exporters could be facing serious pain even if a last-minute Brexit deal gets done.

This brings us back around to the British pound, and the inherent advantage the U.K. government has in the ability to weaken its currency on purpose.

Because a too-strong currency can be devastating for the export sector of an economy, the ability to weaken one’s currency deliberately, as need be, is a feature rather than a bug.

It is also, quite notably, a feature that the 27 E.U. member countries do not have, given how they are tied to Germany, and the top-down monetary policy of the European Central Bank (ECB), and the euro as a single currency. 

Given the pain ahead for U.K. exporters, and their deep importance to the U.K. economy, we anticipate the U.K. government will decide, at some point, to take a page from the 1992 playbook and deliberately weaken their currency once again.

If the British pound is devalued sharply, or even crashes out to significantly lower levels, that could make it far easier for desperate U.K. exporters to compete in a “No Deal Brexit” world come 2021.

Nor should this result, if it happens, be seen as anti-U.K. or unfriendly to the British people: If the U.K. government is forced to devalue the British pound by a large amount, it will be in an effort to save the U.K. economy from deadly contraction, not to harm it further, and it may well be the proper thing to do.

In TradeSmith Decoder, we are short the British pound/U.S. dollar forex pair (GBP/USD) and will be watching developments closely, in terms of both price action and Brexit-related events, for opportunities to add size to the position.


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