The slump of the Pound Sterling last week was said to be a reaction to the UK’s new Prime Minister Liz Truss’ tax cut proposal. An exchange rate represents the purchasing power of money. An excess of it results in depreciation. A government planning to finance its budget deficits by printing money will be bound to devalue a currency. This is the story behind the Sterling crisis. Simple as it appears, however, there are technicalities in operationalizing such a hypothesis. Moreover, there are also other factors beyond the fiscal sector that affects the exchange rate.
Fiscal deficits are common everywhere, especially in advanced economies. While the UK has fiscal deficits, the U.S. has that as well. Thus, the correct explanatory variable should be the difference or ratio between the government budget deficits of the U.S. and the UK. The standard normalized presentation of it is the budget deficits expressed in terms of GDP. This has the advantage that both deficits and GDP are in local currency so the ratio has no unit. Accordingly, the difference between UK’s and U.S.’s deficits-to-GDP can be obtained easily.
In theory, the larger the deficits, the worse the exchange rate. Deficits appear as negative, the more negative the local-to-foreign deficits-to-GDP ratio, the lower the exchange rate. Thus, from the accompanying chart, one should see a co-movement between the blue and red lines should the theory be practical. However, the correlation between the two in the past suggests the fiscal balance gap between UK and U.S. leads Sterling-Dollar by about two years. That says budget balance is somehow predictive of to exchange rate and has been for quite some time.
Nevertheless, the correlation somehow has broken down since 2016/18 (blue/red). The fiscal status of the UK has been much improved relative to that of the U.S. since Brexit (2016). However, the Pound Sterling against the U.S. Dollar (GBP/USD) has not appreciated correspondingly. One of the reasons is the Federal Reserve has increased interest rates by 2.25 percent (9 of the 25 basis points) while the Bank of England only made a 0.5 percent move. As the exchange rate is governed strictly by the interest rate parity, such a widening (negative) UK-US rate gap has made GBP/USD weak.
From mid-2020 to the latest reported quarter (2022Q2), the UK-US deficits-to-GDP gap has been narrowed down from +4.8 percent to –0.5 percent. The reason is not the UK deteriorating; in fact, the number improved from minus 14.7 percent in early 2021 to the latest of minus 4.8 percent. Instead, it was the U.S. that improved even more but by not much: from minus 16.8 percent to minus 4.3 percent over the same period. One can see the fiscal status between them is highly similar. From a longer view since 1984, the gap (blue line) averaged to nearly zero mean, and the latest value is indeed very close to zero.
It turns out that GBP/USD did not appreciate as the fiscal balance implied. Symmetrically, GBP/USD might not depreciate simply because of worsened UK fiscal deficits, if it happened. It seems the “Sterling crisis” has quite some factors other than deficits, such as the unwinding of risk-off assets.
