The pound has hit a record low against the dollar after the UK government announced sweeping tax cuts in a mini-budget last Friday. So why is sterling falling so steeply, and what does that mean for the rest of the world?
What is a currency crisis?
When foreign exchange markets turn against a country, the value of that country’s currency begins to plummet. For instance, Turkey’s currency is worth about 40% less against the US dollar than last year after traders were spooked by a rise in annual inflation to more than 70%.
The British pound has slumped in recent weeks as markets have become disenchanted with the new administration under the newly appointed prime minister, Liz Truss. She signalled an expansive economic policy based on wide-ranging tax cuts.
Her chief finance minister, or chancellor, Kwasi Kwarteng, has been accused of ignoring a 9.9% inflation rate that economists said was only going to worsen, instead choosing in Friday morning’s mini-budget to pump lots more money into the economy. Currency traders have given their verdict over the weekend and Monday, sending the pound from almost $1.20 to a record low of $1.03 before a partial recovery to $1.06.
A sudden and sharp drop in sterling creates uncertainty, throwing the plans of UK businesses that import and export goods into disarray. They expect to pay a specific sum for imports and get a certain price for goods and services they sell abroad. All that changes when the currency falls. If the pound is worth less, the cost of importing goods from overseas goes up.
What does it mean for the UK?
A weaker pound means price rises for UK consumers who buy foreign goods, and it means their money won’t go as far if they travel to the US or countries that use the US dollar.
Oil is one of the key goods Britain imports and it is priced on international commodity markets in dollars. A weak pound will make filling up a car with diesel or petrol more expensive. Gas is also priced in dollars.
The UK also imports more than 50% of its food, so the cost of everything from artichokes to bananas goes up.
Why is it happening?
Truss wants to go ahead with tax cuts in the new year paid for by higher government borrowing. She believes the extra cash will be used to fund investment and improve the UK’s productivity. But sceptics say putting more money in the hands of individuals will increase demand and push inflation higher. A pledge by Kwarteng at the weekend to cut taxes further in the new year has only heightened fears of inflation shooting up again.
Investors are also concerned that extra borrowing will not be recouped through higher growth and improved tax receipts, leaving the UK with worsening debts over the long term.
Part of the pound’s weakness is also the strength of the dollar, which has been rising as the US central bank, the Federal Reserve, aggressively raises rates. The pound sell-off has accelerated significantly, however, after the tax cuts announcement.
How will this affect other countries?
It makes goods and services and assets in the UK cheap. Foreign investors might go on a spending spree to hoover up assets that would otherwise have cost much more to buy. Tourists visiting the UK will also have more money to spend and can take advantage of the improved exchange rate.
Investors that have previously bought UK assets will see the value decline. Some investors will respond by insisting their investment returns are paid in dollars. Others will sell the asset, especially if they believe the currency is likely to fall further.
What is the UK government doing about it?
The next step is likely to be taken by the Bank of England, which could raise interest rates by more than previously expected. It is possible the Bank might announce an emergency increase before its next scheduled policy decision on 3 November.
In a statement on Monday it said officials would “make a full assessment at its next scheduled meeting of the impact on demand and inflation from the government’s announcements, and the fall in sterling, and act accordingly”.
Higher interest rates attract savings deposits to the UK and tend to increase the value of the pound. However, they also increase the cost of borrowing for households and businesses.
In the past, governments have sought to reassure markets by announcing how they intend to cut public spending budgets to balance the books.