Written by Adam Chester, Head of Economics, Commercial Banking, Lloyds Bank
ALTHOUGH the outcome of the EU referendum was a shock, it was widely predicted that the immediate aftermath of the vote to leave the EU would see a dramatic fall in the value of the pound, and so it came to pass.
Sterling has fallen by 10% against the dollar and by similar amounts against other major currencies.
What was striking was that the rise in the FTSE 100 in the immediate aftermath of the referendum pretty much mirrored the fall in the pound.
For the blue-chip index, which includes a high proportion of multinationals, the depreciating pound is positive, as it increases the value of their foreign earnings.
But for businesses with predominantly domestic operations, the picture is very different.
Buying power pared
It’s too early to tell the impact on the real economy, but business and consumer confidence have been hit hard by uncertainty.
A string of profit warnings followed. Sports Direct warned it would be significantly hit by the sharp fall of sterling, as it imports much of its stock from China, where suppliers are paid in dollars.
Given the sharp fall in the pound against the dollar since the referendum, it’s not hard to see how big importers have seen their buying power eroded.
They will now be mulling whether to absorb the higher prices they are having to pay and narrow their profit margins, try and find cost savings elsewhere, or pass the higher costs on to their customers by hiking prices.
Retailers will have been hit by a double whammy, with Brexit coming in quick succession to the imposition of the National Living Wage in April, so there may be very little wiggle room left.
However, a cheaper pound is a fillip to exporters, whose goods will be much more affordable overseas.
A Brexit boon?
Clearly there are shades of grey here, with many exporters importing their raw materials as well, but the devaluation is a potential boon for manufacturers like fashion brand Burberry, which sells more goods overseas than at home.
That could help the UK close its yawning trade deficit and help the government towards its target of exporting £1 trillion of goods and services by 2020.
And Brexit brings with it the potential for the UK to strike its own trade deals directly with faster-growing overseas markets. Australia has already indicated it is keen to sign a deal as soon as possible.
In the meantime, with medium and long-term volatility elevated, firms need to ask themselves whether they can afford another dramatic fall or rise in exchange rates further down the line.
That exposure can be managed, perhaps through forward exchange contracts that allow them to buy and sell currencies at a fixed exchange rate for a specified period, so they can plan for the future with greater certainty.
At least the cost of borrowing is likely to remain lower for longer.
Though the Bank of England’s Monetary Policy Committee declined to cut interest rates in July, there are indications this could happen in August.
With interest rates already close to zero, the Bank of England may choose to focus its efforts on other ways of stimulating the economy. This could include increasing quantitative easing, broadening the range of assets it is prepared to buy, expanding the Funding for Lending scheme or some other forms of credit easing.
For now though, policy makers are keeping their powder dry until they have had an opportunity to assess more fully the impact the UK’s decision to leave the European Union may have on the economy and financial markets.
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