Sterling sell-off now on the cards

British expats working in the Gulf must look on in alarm as they watch the precipitous decline of sterling, even if they are lucky enough to be away from the UK right now. Economically at least, Britain is a mess.

Consider the two charts here. According to data from both the OECD and the IMF, the UK has the worst underlying budget deficit of any major economy in the world.

The charts come from Credit Suisse, a bank that last week slapped a currency 'target' of $1.35 on the US/Sterling rate – a 10 per cent fall from where we currently stand.

According to one of the top Credit Suisse strategists, Andrew Garthwaite, the UK is the most vulnerable to a government debt funding crisis outside so-called 'peripheral Europe,' which means Portugal, Italy, Greece and Spain.

In his latest global equity strategy missive to Credit Suisse clients, Garthwaite rattles off some other reasons why a determined sell-off of sterling is now likely to be on the cards – despite the sharp falls we have already seen:

- As a proportion of GDP, the UK's reliance on quantitative easing has been greater than any other country. What's more, Britain's monetary easing programme has been hugely reliant on the Bank of England purchasing government debt, unlike Japan and the US where either local commercial banks or foreign investors have taken the strain. That points to trouble in the future as the Bank tries to withdraw monetary stimulus.

- Housing in the UK is still more overvalued than in the US. Says Garthwaite: "The house-price-to-wage ratio is still between 15 per cent to 20 per cent above average in the UK, while in the US the house-price-to-wage ratio is 10 per cent below its average. After a 10 per cent recovery in house prices, the best lead indicators of housing have begun to weaken, with mortgage approvals falling 19 per cent since November, house prices down one per cent in February (according to Nationwide) and RICS survey of new buyer enquiries falling for eight out of the last nine months."

- Ordinary Brits are deeper in debt. Garthwaite says: "The household sector is more overleveraged than in the US. The ratio of household liabilities to income is 27 per cent per person (pp) higher than in the US (155 per cent versus 128 per cent), while the ratio of financial liabilities to financial assets is six pp higher."

- British banks are in a worse state than their counterparts on the other side of the Atlantic. He says: "The leverage and liquidity position of UK banks is worse than the US. The loan-deposit ratio is still 140 per cent and asset-to-equity ratio at 28x are both higher than the US. Our UK banks analyst, Jonathan Pierce, highlights that under the new Basel regulation UK domestic banks might have to shrink their balance sheets between 15 per cent and 30 per cent."

- The financial markets are already betting that inflation will prove more of a problem in the UK than in the euro zone. Again, Garthwaite says: "The gap between UK and US and euro zone inflation swaps has widened in recent years, suggesting that the UK's inflation-fighting credibility is in question. The five-year inflation swaps are around 100 bps higher than in the euro zone and the US, with core inflation, at 3.1 per cent, running well ahead of the other major economies."

Get the picture? Britain is exposed. Seriously exposed. Ironically, the openness of the British economy makes it more susceptible to imported inflationary pressures, which are the natural consequence of sterling's decline – and the weakness of the currency right now is at least in part down to the markets factoring in those pressures in advance. For what it's worth, Garthwaite and his team reckon the expected inflationary spike in the UK will be short-lived – mainly because of the flexibility of the UK workforce in terms of wages. The Credit Suisse house view is for prices rising 2.3 per cent this year and just one per cent in 2011. Also, the very fact that the Bank of England will see inflation as a non-threat bolsters the idea that Britain's central bank will be relaxed to see Sterling fall further from its current levels.

But there's one other important factor behind sterling's weakness: politics. A general election is due in the UK by June 3 and that prospect has made the financial markets even more concerned about government financing than would otherwise have been the case. The markets are rooting for the Conservatives – not because market participants are inherently right-wing, but because they fear a hung parliament that would struggle to impose the sort of austerity measures that the UK's balance sheet so badly needs.

And here's a warning from Garthwaite. The Conservatives probably require an eight percentage point lead in the polls in order to have a majority [in terms of seats]. Recently, their lead in the polls has slipped from 26 percentage points [at the peak in May 2008] to around six percentage points. The markets would question the workability of a minority government [the last one was installed in February 1974 and lasted just eight months; in 1976 the IMF were called in]. It is important to note that it is up to the incumbent Prime Minister not the party who wins the most seats, to try to form the next government [as indeed Ted Heath tried to do in February 1974, after he had won fewer seats than Labour]. This could be problematic, given that Labour has no spending targets whatsoever after FY2010-11, something that we believe that financial markets would find unacceptable in the longer run."

Are there any reasons to be cheerful here, you might ask? The answer is a hesitant "yes" – some indicators point to economic momentum in the UK, compared with other countries, accelerating sharply just recently. But then the party poopers would just put that down to the outsized quantitative easing programme undertaken by the authorities.

All of which leaves us with one thing to look forward to: Britain will be a cheap place to visit.

- The writer is an Associate Editor with Financial Times


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