Why the pound is falling and how it will affect you

pound coins

The value of the pound has fallen dramatically this year. If you wanted to exchange £100 into euros today, you'd get roughly 116 euros. But if you had made the transaction on 2nd January, you'd have got around 123 euros. That's a 5% fall in less than a month.

I fear we're in the early stages of a 'currency war' that could destabilise the world economy.


So why is a currency war likely?

The trigger has been the economic policy of the new Japanese government.

The new Prime Minister, Shinzo Abe, has made it very clear that he wants higher inflation in Japan and a cheaper yen. And he's willing to do pretty much whatever it takes to achieve that.
Japan is still the world's third largest economy, so any such move is bound to trigger problems worldwide. Remember, if the yen falls, Japanese goods will be cheaper in the US and China.

And the American and Chinese governments won't be happy if they think that Japan has gained an unfair advantage.

So we could easily see China and the US taking steps to make sure that their currencies don't rise against the yen. Hence a currency war.

The pound

Before I go any further, I should say that I don't think the recent falls in the pound are purely due to what's going on in Japan. I think there are four other causes:
  1. Europe is looking a little less sickly, so some investors are now transferring their money out of the UK and into the Eurozone, boosting the value of the euro.
  2. Mervyn King, the Governor of the Bank of England, hinted in a speech last week that he'd like to see a cheaper pound.
  3. There are concerns that the UK Government's credit rating may be downgraded.
  4. There's a growing realisation that the UK's persistent trade deficit isn't going away and may be getting worse. In other words, we buy more goods and services from abroad than we sell abroad. And we also own fewer foreign assets than we used to. (We've had to sell assets to cover the cost of our trade deficit.)

Given these factors, and the early signs of a currency war, I think there's a strong chance that the pound will fall further this year.

So what will that mean for the likes of you and me?

1. Overseas holidays will become more expensive

If the pound is weaker against the euro, all your euro-based costs will go up. That's bad news if you fancy a holiday in the likes of France, Spain or Italy this year.

If you're sure you want to holiday abroad this year, it may be worth buying some foreign currency now so that you don't get caught out if/when the pound falls further. That's assuming you can find any spare cash to spend on foreign currency right now.

2. Inflation may go up

A weaker pound should push up the price of imported goods in the UK. So that could lead to higher inflation than would otherwise be the case.

3. Exporters could see more business

Just as the price of imported goods goes up, the price of goods that we export abroad will fall. So if you work for a firm that does a lot of business abroad, your boss may be slightly happier this year as business picks up a bit.

4. A potentially unstable economy

If we do get full global currency war, that could then lead onto a 'trade war' if world leaders aren't careful.

In other words, if governments feel that another country is playing 'fast and loose' with its currency, they might impose tariffs or quotas on imported goods. These tariffs might deliver a short-term boost to a particular country's economy, but history suggests that tariffs aren't a good idea in the long term.

Reduced trade tends to lead to reduced efficiency and lower growth.

In fairness, I doubt that we will get a full trade war – perhaps naively I think that most politicians and central bankers have learned some lessons from the past.

More than a blip

However, I doubt that the pound's fall this month will prove to be just a blip. You can never be certain about currencies but I strongly suspect that we'll see further falls in the pound this year and a fair amount of volatility in the global currency markets.

Yes, a lower pound will benefit exporters, but overall, I'd prefer stable currencies as the background to a steady global recovery. Shame that probably won't happen.
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