BOE Master Plan in the Works?

Last Friday, the pound took a hit when the Bank of England‘s MPC officials started talking about… gulp… the possibility of a double dip recession. MPC Member Andrew Sentance said that the economy was still unstable and that any downside surprises could push the UK back into recession. This sparked speculation that the BOE is still glum about the prospects of the UK’s recovery.

This seems to be in line with what BOE head Mervyn King wants. After all, a few weeks back, he practically ignored the concerns of rising inflation, saying that the economy was still fragile and needed more stimuli. Hey, if the King says something, shouldn’t it be natural that his soldiers follow suit?

The skeptic in me thinks that this could be part of BOE’s master plan. You see, my forex friends, there is this not-so-far-fetched theory floating around here at BabyPips.com headquarters that the BOE actually wants to devalue their beloved pound.

Traditionally, a country wants to devalue its currency in order to improve its trade balance. By devaluing the pound, the British exports will essentially become cheaper, and thus become more attractive relative to its competitors. Doing so will also discourage imports as they will become more expensive in terms of the pound. With the UK’s export industry contributing about 17% to its total GDP, weakening the pound could jack the country’s GDP a couple of notches.

But is this really why the UK reportedly wants to bring down the pound?

Word on the street is that the BOE wants the pound to fall so that the British government has an easier time in servicing their debts. Devaluing the pound also reduces the value and the cost of the UK’s public debt, which presently stands at a massive £848.5 billion (59.9% of its GDP). By weakening the pound, the UK’s debt would be paid off by inflated currency. Relative to the other currencies, the value of what they owe will decline.

To illustrate, let’s say that the UK owes the US £1 million at a GBPUSD rate of 1.5000 which is equivalent to $1.5 million. If the exchange rate between the two currencies, however, falls to 1.0000, the UK will only have to pay the US an equivalent of $1 million. That’s $0.5 million off the UK’s government balance sheet! Effectively, they will just be printing new money to pay for what they owe.

Sounds like a good idea? Well, not exactly.

Having a weak currency during times of poor economic performance could lead to some serious negative consequences. Remember, unemployment is still exorbitantly high, which is putting a strain in consumer spending. In my humble opinion, introducing inflation through a weaker currency in a time like this will only make things worse.

Purposefully debasing a nation’s currency has this nasty effect of driving up import prices. Off the top of my head, assuming the UK purchases most of its raw materials abroad, the costs businesses incur in production increases. The dramatic rise in costs will eventually bite British consumers in the behind as employees demand higher wages to keep up with climbing prices. This develops into a pretty ugly vicious spiral. History tells us that economic strength comes from solid fundamentals, and not by simply debasing the local currency….

Besides, a further devaluation of the pound will only push inflation to misleadingly high levels, burying the British economy deeper in stagflation. Before you know it, policymaker Andrew Sentence’s prophecy of a double-dip recession could be fulfilled and put UK right back to where it started.

Where could the pound be off to then? Below its yearly lows of 1.3900, perhaps? Currently, the GBPUSD is testing the 1.5000 handle, which could break after the release of the UK’s inflation and budget reports this week. Downbeat figures could send the pound tumbling lower, just as the BOE wanted – at least in the short term. The challenge is for them to be able to contain this slide just before a massive depreciation of the pound severely damages their economy…

  • HarryPilgrim

    I see Mervyn King is talking down the UK economy today, which would tend to support your view. Certainly a weaker pound reduces the potential for more QE. That exports have not risen in spite of the this year’s depreciation is bad news in itself: either UK exports are not price sensitive or the rest of the world is not growing it’s imports.

    I think the Bank is a relatively safe pair of hands though, the real danger-man is our Darling Chancellor. Take cover before the budget!

  • HarryPilgrim

    I see Mervyn King is talking down the UK economy today, which would tend to support your view. Certainly a weaker pound reduces the potential for more QE. That exports have not risen in spite of the this year’s depreciation is bad news in itself: either UK exports are not price sensitive or the rest of the world is not growing it’s imports.

    I think the Bank is a relatively safe pair of hands though, the real danger-man is our Darling Chancellor. Take cover before the budget!