Why is the British pound plummeting as the US dollar skyrockets? | Business and Economy

As the British pound is plummeting in value, the US dollar is flying high.

In a tumultuous scenario that includes the war in Ukraine, the price surge and the COVID freeze in China, the sharp fluctuations of some of the world’s major currencies are injecting new uncertainty into the global economic outlook.

Why is the British pound in free fall?

The pound fell to an all-time low against the U.S. dollar on Monday as investors rushed to sell the currency and government bonds with a major vote of no confidence in new Prime Minister Liz Truss’s economic plans, which include massive cuts. to taxes financed by large increases in public debt.

The pound fell as low as $ 1.0327 at one point in Asian trading, surpassing its previous record low in 1985, before recovering some of its value.

The price of UK 5-year bonds, through which investors lend money to the government, has seen the sharpest decline since at least 1991.

Under Chancellor of the Exchequer Kwasi Kwarteng’s “mini budget” announced on Friday, the UK proposes the largest tax cuts in the last 50 years, including the abolition of the 45% tax rate on incomes above £ 150,000 ($ 162,000) .

The tax cuts, coupled with a plan to support rising household energy bills, will require the government to borrow another £ 72 billion ($ 77.7 billion) in the next six months alone.

British Chancellor of the Exchequer Kwasi Kwarteng has proposed the biggest tax cuts of the past 50 years [File: Maja Smiejkowska/Reuters]

As with other goods and services, the value of most major world 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 plunge in the value of the pound indicates that investors are concerned about the UK’s ability to handle so much extra debt, especially as rising interest rates make borrowing much more expensive.

On Monday, Raphael Bostic, a senior US Fed official, warned that the fiscal review had “really increased uncertainty” and increased the risk of a global recession.

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

“The new prime minister’s economic policy of lowering taxes on the rich is not very popular and the consensus is that it won’t work to stimulate the economy.”

While the UK’s fiscal plans were the initial trigger for the pound’s free fall, economists say investor confidence in the UK economy has long declined due to developments such as Brexit.

“The British pound has long suffered from political decisions in the UK,” Alexander Tziamalis, a lecturer in economics at Sheffield Hallam University, told Al Jazeera.

“He has been hit by Brexit and is also facing the prospect of a second referendum on Scottish independence and a potential trade war with the EU over the Northern Ireland Protocol.”

What can the UK do to stop the pound’s decline?

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

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

But despite calls from some economists for emergency action, the UK central bank opted for an unscheduled rate hike, dropping the pound to $ 1.06 after making some earlier gains.

“Both the Bank of England and the Bank of Japan may decide to raise rates to match the rise in 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 the BoJ – then not just a rate hike, but a larger-than-expected rate hike – it won’t help much with currency values. The problem with aggressive interest rate hikes is that it is likely to push the economy into a recession, which nobody wants to see. ”

Governments can also intervene by buying their own currency to support its value, although this is frowned upon by many economies and risks invoking trade sanctions.

“The pound and the yen are officially floating exchange rates, governments shouldn’t and don’t often intervene in the forex market,” said Tien.

Why is the US dollar so strong?

The strength of the US dollar, which has been on an upward trajectory since mid-2021 and reached its 20-year high against six major currencies last month, has two main factors.

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

In much the same way that a weakening of the currency reflects the decline in investor confidence in a country’s economy, a strengthening of the currency indicates a vote of confidence in an economy’s fundamentals.

While the US economy is battling high inflation and weak growth, the dollar has long been regarded by investors as a reliable bet.

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

“So with the war in Ukraine, economic and political problems in Europe, high inflation, etc., it is not surprising that investors are turning to the US dollar.”

Marc Chandler, chief market strategist at financial advisory firm Bannockburn Global Forex, said the US looked like a safe bet for investors in light of global events, even though it has experienced negative growth in the past two quarters.

“The biggest rivals of the United States shot themselves in the foot. Here I am thinking of the Russian invasion of Ukraine and China’s zero-Covid policy that has disrupted growth, ”Chandler told Al Jazeera.

“The allies of the United States are also facing serious struggles. Japan is the only G10 country not to raise interest rates. China has actually cut rates recently. Europe is on the verge of a recession and the new UK government has sparked discussions about the crisis with its fiscal stimulus adding to its current account deficit. ”

The second driver of the dollar’s rise is the rise in interest rates by the US Federal Reserve, which has raised the cost of borrowing in an attempt to tame the surge in inflation.

With US bank depositors benefiting from interest rates, investors were further encouraged to exchange other currencies for dollars, driving up the greenback price.

“Of course, central banks in other jurisdictions such as the UK have also raised interest rates and the eurozone plans to do the same. But they are not acting as aggressively as the United States, “said Tziamalis, a lecturer in economics at Sheffield Hallam University.

“Meanwhile Japan is not shrinking at all, so the net result is still higher overseas demand for greenbacks.”

Who are the winners and losers?

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

For everyone else, the picture is less rosy.

A stronger dollar not only means more expensive American imports and trips to the United States, but is likely to exacerbate inflation in general in other countries.

Oil and other commodities such as metals and timber are usually traded in dollars, increasing their cost in local currency. Rising energy prices, in turn, will drive up the cost of other goods and services.

“The only exception is the United States, where a stronger dollar makes it cheaper to import consumer products and therefore could help tame inflation,” Tziamalis said.

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

“As a result, many countries will struggle to find more and more local currency to service their debts,” said Tziamalis.

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

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