The pound is plunging into near-historic depths. Why?

Kwasi Kwarteng, British new chancellor of the Exchequer, insists that he is not one to be moved by exchange rate fluctuations.

“The markets will react as they will,” he told the House of Commons on September 23 after unveiling the the biggest series of tax cuts in half a century, largely financed by borrowing.

His recklessness was put to the test. On September 26, the The pound is collapsing against the US dollar as markets opened in Asia, briefly dipping below US$1.04.

The drop came on the heels of a hurtful selloff on Friday, following Kwarteng’s announcement. During Asian trading hours, the pound stabilized at around US$1.07, down around 1%, as interest rate expectations rose.

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The currency’s historic low, measured by the price at 4 p.m. in London, was reached on February 26, 1985, at US$1.042.

This year, as in 1985, much of the pound’s decline actually reflects the strength of the dollar. The pound is down about 20% against the greenback in 2022, not much more than the euro’s 15% and in line with the fall in the Japanese yen.

But last week, the pound slumped against most currencies, not just the US one.

This drop has been accompanied by a rise in government bond yields, which would generally encourage international investors to buy sterling-denominated assets in the expectation of higher yields.

British Chancellor Kwasi Kwarteng speaks on Friday after unveiling sweeping tax cuts.

Jessica Taylor/UK Parliament

British Chancellor Kwasi Kwarteng speaks on Friday after unveiling sweeping tax cuts.

UK five-year yields have risen from 1.5% in early August to over 4.5% today: a rise of around one percentage point in just two days.

This combination of rising yields and a falling currency has sparked talk of a broader crisis of confidence in the UK economy and its assets. The government’s tax cuts will translate into a growing budget deficit and higher public debt levels in the future.

Britain’s current account deficit hit 8.3% of GDP in the first three months of the year, the deepest in modern history, driven by soaring energy prices. A gaping current account deficit is something that often worries those investing in developing economies.

But in other respects, Britain is an unusual candidate for a currency crisis.

Its exchange rate is flexible, meaning there is no link to any other currency, as was the case when Britain was kicked out of the European Exchange Rate Mechanism in 1992. Its financial markets are deep and sophisticated. It has minimal debt denominated in foreign currencies and its central bank is independent from the government.

So the simplest explanation for the sell-off is that investors don’t believe the government’s tax cuts will lead to the real economic growth that Kwarteng wants. Instead, they predict higher inflation that the Bank of England will be unwilling to fully offset with interest rate hikes.

Currency analysts at Bank of America suggest that a combination of Britain’s changing fiscal stance and the long-term effects of its decision to leave the European Union has led to a deep overhaul of the pound by the investors. This makes the currency more vulnerable in the coming years.

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