The chances of a strong pound are still bleak

Kathleen Brooks
SO WHAT now for the pound? Not even a Conservative-led coalition and a credible plan to cut public spending has been enough to lift the UK currency out of its malaise – it has fallen 5 per cent against the dollar in the past month and has been unable to break above the €1.18 mark against the euro. This has defied some market commentators who thought the pound was due a correction once the election was out of the way and the Labour Party was unseated from power.

But now analysts at Bank of Tokyo-Mitsubishi UFJ expect sterling to fall to $1.38 against the US dollar in the coming months as the new Lib-Con coalition government’s honeymoon period comes to an end. So why has the pound stalled? There are three factors weighing on sterling: fears about growth, the UK’s exposure to Europe and investors’ reactions to changes to the tax regime.

Firstly, although the market broadly welcomed plans to cut public spending, Duncan Higgins from Caxton FX says that the focus has now turned to the impact this could have on economic growth: “There are risks that these cuts could undermine the strength of the recovery. Monetary policy will likely be kept loose longer than was initially expected to accommodate these cutbacks, which provides another drag on the currency.” Added to this is the enormity of the task at hand: the UK’s net debt burden as a percentage of GDP has surged in recent years (see chart) and this round of spending cuts is only the tip of the iceberg.

Secondly, the UK’s largest trading partner is Europe, and with growth there expected to slow as austerity measures and budget constraints kick in, the UK could find that its exports fall even though the pound is weak. This is already being seen in the economic data – the UK’s trade deficit actually widened in March to £3.7bn from £2.2bn in February, according to figures from the Office for National Statistics, and this was before the extent of the debt crisis in Southern Europe came to the public’s attention.

Lastly, some argue that the UK’s new tax regime could hurt sterling. Laffer Associates, an independent economic research company founded by Art Laffer, the supply-side economist who became popular during the administration of President Ronald Reagan in the US, has noted that a paradigm shift in the UK’s attitude to taxation will weigh on the pound. “If the United Kingdom continues travelling down its current policy path, the result will be economic stagnation à la the 1970s”.

Planned increases to capital gains tax and value added tax, along with the hike in the top rate of income tax to 50 per cent from 40 per cent, could actually reduce the amount of revenue the government collects, it argues. “Britain’s government believes that these increases in tax rates are necessary to prevent financial catastrophe. However, it fails to remember that raising tax rates does not necessarily raise revenue. The Laffer curve states that after a certain tax rate, revenues begin falling, and this is exactly what the UK could experience over the coming years – putting it in an even more difficult financial position”.

Laffer Associates argues that overly complex progressive tax regimes will be too high to bear and will stunt economic growth for the foreseeable future. Instead it suggests “fundamental tax reform that replaces the UK’s progressive tax system with a flatter, more broad-based tax structure,” as the best remedy to the UK’s problems.

The extent of Britain’s economic and fiscal problems is truly epic, and it is only at the start of its journey to recovery. All of which means that right now there are few reasons to support a stronger pound.