Deutsche Bank says sterling crisis risks are rising as Truss takes over as PM
A sign picture of Deutsche Bank in front of the German stock price index, DAX board, at the Frankfurt Stock Exchange, Germany, September 30, 2016.
Following the news that Liz Truss will become Britain’s new prime minister, Deutsche Bank says policy announcements in the coming weeks will be crucial if the UK is to avoid extreme macroeconomic events, particularly the balance of payments crisis.
Truss won the race to succeed Boris Johnson as leader of the ruling Conservative Party on Monday, after a long contest against former finance minister Rishi Sunak. Truss received 81,326 votes from Conservative Party members, while Sunak received 60,399 votes.
The pound rose against the dollar in part on Monday, trading just below $1.15, but Shreyas Gopal, a forex strategist at Deutsche Bank, warned that the risks of the “sterling crisis” should not be underestimated.
“With the current account deficit already at record levels, the pound requires significant capital inflows supported by improved investor confidence and declining inflation expectations. However, the opposite is happening,” Deutsche Bank said in a note on Monday.
“The UK has the highest inflation in the G10 and weak growth prospects. Large, untargeted and untargeted fiscal expansion coupled with potential changes to the BoE’s mandate could lead to a greater rise in inflation expectations and – in the extreme – the emergence of financial dominance.”
Truss has put the Bank of England and Governor Andrew Bailey badly in the crosshairs during its leadership campaign, blaming the central bank for allowing inflation to rise to its highest levels in 40 years, and is said to be considering a review of the bank’s mandate.
It has also suggested scrapping the Northern Ireland Protocol, a key part of the post-Brexit withdrawal agreement between the UK and the EU, a move likely to lead to retaliation from the bloc.
Gopal suggested that additional uncertainty over trade policy would further cloud the macroeconomic picture and weaken investor confidence.
“The risk premium on British bonds is already rising, in conjunction with unusually large outflows. If investor confidence declines further, this dynamic could become a self-fulfilling balance of payments crisis as foreigners will refuse to fund the UK’s external deficit,” he said. .
Deutsche Bank estimates that trade-weighted sterling – a measure of the value of the pound against selected currencies most important in international trade – must fall another 15% in order to bring the UK’s deficit back to the 10-year average.
“The balance of payments financing crisis may seem severe, but it is not unprecedented: a combination of strong fiscal spending, a severe energy shock, and a decline in sterling eventually led to the UK resorting to an IMF loan in the mid-1970s,” Gopal said.
“Today, the UK maintains some key lines of defense against a sudden stop, but we are concerned that the risks are rising nonetheless.”