Why does the British pound appreciate as the US dollar rises? | Business and Economics

As the British pound falls, the US dollar soars.

Against a turbulent backdrop that includes the Ukraine war, soaring prices and China’s COVID-related bans, sharp swings in some of the world’s major currencies are adding new uncertainties to the global economic landscape.

Why is the British pound in freefall?

The pound fell to a record low against the US dollar on Monday as investors rushed to sell currencies and government bonds amid a major vote of no confidence in new Prime Minister Liz Truss’s economic plans. in public borrowing.

At one point in Asian trading, the pound fell as low as $1.0327, surpassing the previous record low reached in 1985 before regaining some of its value.

The price of 5-year UK bonds, which investors lend to the government, fell by the sharpest since at least 1991.

Under the “mini budget” announced by Chancellor of the Exchequer Kwasi Kwarteng on Friday, Britain is offering its biggest tax cuts in 50 years, including scrapping the 45 percent tax rate on incomes above 150,000 pounds ($162,000).

The tax cuts, along with a plan to support rising household energy costs, will require the government to borrow an extra 72 billion pounds ($77.7 billion) in the next six months alone.

UK Treasury Secretary Kwasi Kwarteng has proposed the biggest tax cuts of the last 50 years. [File: Maja Smiejkowska/Reuters]

As with other goods and services, the value of most of the world’s major currencies operates on the principle of supply and demand.

When the demand for a particular currency is high, the price goes up and vice versa.

The fall in the pound suggests investors are worried about the UK’s ability to manage so much extra debt, especially as rising interest rates make borrowing more expensive.

On Monday, top US Fed official Raphael Bostic warned that the tax overhaul “really increases uncertainty” and raises the risk of a global recession.

“Confidence in the UK economy is currently low,” Pao-Lin Tien, an associate professor of economics at George Washington University, told Al Jazeera.

“The new prime minister’s economic policy of cutting taxes for the rich is not very popular and the consensus is that it will not work to stimulate the economy.”

While the UK’s tax plans were the initial trigger for the pound’s free fall, economists say investor confidence in the British economy has been waning for some time due to developments such as Brexit.

Alexander Tziamalis, a senior lecturer in economics at Sheffield Hallam University, told Al Jazeera that “the British pound has been suffering for a long time because of political decisions in the UK.”

“Struck by Brexit and also facing the prospect of a second Scottish independence referendum and a potential trade war with the EU over the Northern Ireland protocol.”

What can the UK do to stop the pound falling?

The main tool available to strengthen the pound or any other depreciating currency is to raise interest rates to attract foreign investors with better returns.

On Monday, Bank of England Governor Andrew Bailey said the central bank would not hesitate to raise rates if necessary.

But despite calls from some economists for emergency action, Britain’s central bank resisted an unplanned rate hike, dropping the pound to $1.06 after some early gains.

“Both the Bank of England and the Bank of Japan may decide to raise interest rates to match rising US interest rates,” said Tien, a professor at George Washington University.

“That will help, but if investors don’t see aggressive enough action from the BoE or BoJ, meaning not just a rate hike, but an expected interest rate hike, it won’t help currency values ​​much. “The thing about aggressively raising interest rates is that they send the economy into a recession that nobody wants to see.”

Governments can also intervene by buying their own currency to boost its value, although this is frowned upon by many economies and can lead to trade penalties.

“The pound and yen are officially floating exchange rates, governments should not and should not intervene in the forex market too often,” Tien said.

Why is the US dollar so strong?

There are two main drivers of the US dollar’s strength, which has been on an upward trajectory since mid-2021 and hit a 20-year high against six major currencies last month.

The first is confidence in the US economy relative to its peers.

Likewise, a weakening currency reflects a decline in investor confidence in the country’s economy, while a strengthening currency signals a vote of confidence in the economy’s fundamentals.

With the US economy struggling with high inflation and record growth, the dollar has long been seen as a safe bet by investors.

“The US dollar has always been seen as a safe haven for investors because the US is such a strong and big economy, so if there is global uncertainty, it is always safe to hold the US dollar because it holds its value well,” Tien said. .

“Thus, the war in Ukraine, economic and political problems in Europe, high inflation, etc. it is not surprising that investors turn to the US dollar.

Marc Chandler, chief market strategist at financial consulting firm Bannockburn Global Forex, said the U.S. appears to be a safe bet for investors amid global events, even though it has recorded negative growth over the past two quarters.

“The biggest rivals of the USA have shot themselves. Here I’m thinking about Russia’s aggression in Ukraine and China’s zero-covid policy that is disrupting growth,” Chandler told Al Jazeera.

“US allies are also fighting hard. Japan is the only G10 country not to raise interest rates. China actually lowered interest rates recently. Europe is on the brink of recession and the new UK government has fueled crisis talk with fiscal stimulus to add to the current account deficit.

A second factor behind the dollar’s appreciation is the US Federal Reserve’s interest rate hikes, which are raising borrowing costs to tame rising inflation.

As depositors in US banks benefited from interest rates, investors were further encouraged to convert other currencies into dollars, pushing up the value of the dollar.

“Of course, central banks in other jurisdictions, such as the UK, are also raising interest rates, and the eurozone is planning to do the same. But they are not as aggressive as the US,” said Tziamalis, an economics lecturer at Sheffield Hallam University.

“Meanwhile, Japan is not tightening at all, so the net result is still greater overseas demand for the dollar.”

Who are the winners and losers?

For US consumers, a stronger dollar means cheaper imported goods in stores and more affordable holidays abroad.

For everyone else, the picture is less rosy.

A strong dollar not only means that American imports and travel to the US are more expensive, but it can also fuel inflation in other countries.

Oil and other commodities, such as metals and timber, are usually traded in dollars and increase in value in local currency. Higher energy prices will in turn increase the price of other goods and services.

“The only exception is the United States, where a stronger dollar makes imports of consumer goods cheaper and can therefore help tame inflation,” Tziamalis said.

The strength of the dollar also makes it difficult for many developing countries to service their debts, which are often held in US currency.

“As a result, many countries will find it difficult to find ever-increasing local currency to pay their debts,” Tziamalis said.

“These countries will either have to tax their economies more, issue inflationary local currency, or simply borrow more. The results could be a deep recession, hyperinflation, a sovereign debt crisis, or a combination of all three, depending on the path chosen.

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