By Peter Garnham
Published: December 19th 2008.
So swift has been sterling's fall from grace that something that seemed unthinkable only a few weeks ago - parity against the euro - now seems only a matter of time.
Yesterday, the pound lurched a step nearer parity, as it hit a fresh low of 95.56 pence against the single currency. On a trade-weighted basis, the currency also hit a fresh record low.
One of the few consolations for the battered pound, say analysts, is that it is already a pariah - meaning sentiment towards it cannot get much worse.
"We are probably close to a major low", says Andrea Rogers at TorFX, the currency broker. "Everyone is looking for parity, and whenever a stampede develops in any market it is likely to be nearing the end of a major trend."
Weakness in the pound is nothing new, of course. So far this year, the pound has dropped nearly 23.1 per cent against the euro.
But the pace of its most recent fall against the single currency - it has dropped almost 7 per cent this week - is startling.
That slump has been driven primarily by the UK's greater reliance than the eurozone on services, once the country's great engine of growth, and particularly financial services.
This has seen the effects of the credit crisis spill over more quickly into the real economy, hitting UK house prices and prompting a series of aggressive interest rate cuts from the Bank of England.
Moreover, as the financial crisis has deepened and the UK government has moved to bail out the country's ailing banking system, concerns over the country's finances have weighed on the currency.
Those fears were exacerbated yesterday as data showed the UK budget deficit widened to a record level in November as tax revenue declined in the face of the worsening slowdown.
Longer-term forces have also been at work. Mansoor Mohi-uddin at UBS says the pound was boosted from the late 1990s by rebounding oil prices and an expanding financial services sector. But he says, in the post bubble world, financial services will shrink significantly as a share of UK GDP, while at the same time UK oil production is due to decline sharply.
While these concerns have been driving sterling steadily lower since the summer, the severity of the pound's slump this week has been triggered by the realisation that the UK authorities look set to take more drastic monetary policy action to combat the financial crisis.
Charlie Bean, the Bank of England's deputy governor, said in an interview with the Financial Times that zero interest rates were a possibility and that the government was likely to pump billions more pounds into the banking system as the economy kept slowing.
That raised the prospect that not only was the Bank likely to make a further, aggressive cut to UK interest rates - which currently stand at 2 per cent - at its next meeting in January, but that it might follow the US and adopt a quantitative easing approach to monetary policy.
That means once UK rates fall close to zero, the UK authority's only way of providing monetary stimulus is to pump money into the financial system.
Neil Mellor at Bank of New York Mellon says talk of UK quantitative easing is now becoming "mainstream", and that the Bank only refrained from a larger interest rate cut at its December meeting for fear of destabilising financial markets.
However, sterling's plight has undoubtedly been exacerbated by the flight to the euro. This is because European Central Bank officials, such as Germany's Jurgen Stark, have indicated that eurozone interest rates - currently 2.5 per cent - will only come down in small steps.
European officials have also become increasingly critical of lax fiscal policy with Jean-Claude Trichet, ECB president, recently stressing the importance of respecting the EU's budget rules.
"It requires little imagination to conclude that in the face of simmering concern about the level of policy stimulus in the eurozone, the downside risk to UK interest rates clearly exceeds that for the eurozone," says Mr Mellor. This means the euro could easily strengthen further, he believes.
But some analysts warn the relatively hawkish stance of eurozone policy makers could spell danger for the euro. Steve Barrow at Standard Bank says the ECB is in serious danger of creating an excessively strong currency.
He says the euro's strength is reminiscent of that of the Deutschemark when sterling was ejected from the European Exchange Rate Mechanism in 1992.
Then, Germany faced the shock of reunification with the East which required interest rates so high that the rest of Europe could not live with it. As a result, most currencies plunged against the D-mark.
"Today, there's no asymmetric shock to Germany or any other eurozone country", says Mr Barrow. "This time the credit crisis and recession is a symmetric shock."
He says the ECB is still displaying an inherent conservatism on monetary policy that threatens to create difficulties for the eurozone region as it prices itself out of export markets.
Indeed, David Owen at Dresdner Kleinwort says sterling's fall should not be seen as a crisis but more as a boon for the economy. He says a weaker currency is a textbook solution to a banking crisis and recession as zero interest rates come into view.
"Not every single country can devalue its way out of a problem, so in that sense it is good the UK got there first", says Mr Owen.
"It seems obvious to us that the eurozone needs a weaker exchange rate, and not just the highly-export dependent German economy. So, next year may be a very different story as far as sterling is concerned."
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Copyright The Financial Times Limited 2008
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