Why is the British pound crashing as the US dollar soars? | Business and economy

As the British Pound drops in value, the US Dollar flies high.

Against a tumultuous backdrop that includes war in Ukraine, soaring prices and COVID lockdowns in China, sharp swings in some of the world’s major currencies are injecting further uncertainty into the global economic outlook.

Why is the pound in freefall?

On Monday, the pound fell to a record low against the US dollar as investors rushed to sell the currency and government bonds in a major vote of no confidence in new Prime Minister Liz’s economic plans. Truss, which include big tax cuts funded by big increases. in government borrowing.

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

The price of UK 5-year bonds – through which investors lend money to the government – has registered the biggest drop since at least 1991.

Under Chancellor of the Exchequer Kwasi Kwarteng’s ‘mini budget’ announced on Friday, the UK is proposing the biggest tax cuts in 50 years, including scrapping the 45% tax rate on earnings over 150 000 pounds ($162,000).

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

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UK Chancellor of the Exchequer Kwasi Kwarteng has proposed the biggest tax cuts in 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 increases and vice versa.

The plummeting value of the pound indicates that investors are worried about the UK’s ability to handle so much additional debt, especially as rising interest rates make borrowing much more expensive.

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

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

“The new Prime Minister’s economic policy of cutting taxes on 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 first trigger for the pound’s free fall, economists say investor confidence in the UK economy has been declining for some time due to developments such as Brexit.

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

“He has been hit by Brexit and also faces 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 decline of the pound?

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

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

But despite calls from some economists for emergency action, the UK’s central bank opted against an unexpected rate hike, sending the pound down to $1.06 after making earlier gains.

“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 actions from the BoE or the BoJ – so not just a rate hike, but a bigger than expected rate hike – it won’t help much. with currency values.The problem with massive and aggressive interest rate hikes is that they risk pushing the economy into a recession, which no one wants to see.

Governments can also intervene by buying up 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 foreign exchange market,” Tien said.

Why is the US dollar so strong?

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

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

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

As the US economy struggles with high inflation and sluggish growth, the dollar has long been seen 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 big economy, so if there is global uncertainty, it’s always a safe bet to hold US dollars. because they hold their value well,” Tien said. .

“So with the war in Ukraine, economic and political problems in Europe, high inflation, etc., it’s no surprise that investors are turning to the US dollar.”

Marc Chandler, chief market strategist at financial advisory firm Bannockburn Global Forex, said the United States appeared to be a safe bet for investors in light of global events, even though it posted negative growth during of the last two quarters.

“The biggest American rivals have shot themselves in the foot. I’m thinking here of Russia’s invasion of Ukraine and China’s zero Covid policy which has disrupted growth,” Chandler told Al Jazeera.

“American allies also have serious fights. Japan is the only G10 country not to raise interest rates. China actually recently cut rates. Europe is on the brink of recession and the UK’s new government has sparked crisis talk with its fiscal stimulus that is worsening its current account deficit.

The second driver of the dollar’s rise is interest rate hikes by the US Federal Reserve, which raised the cost of borrowing in an effort to rein in soaring inflation.

With depositors at U.S. banks benefiting from interest rates, investors were further encouraged to swap other currencies for dollars, pushing up the price of the greenback.

“Of course, central banks in other jurisdictions like the UK have also raised interest rates, and the Eurozone plans to do the same. But they are not acting as aggressively as the US,” said Tziamalis, professor of economics at Sheffield Hallam University.

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

Who are the winners and losers?

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

For everyone else, the picture is less rosy.

Not only does a stronger dollar mean more expensive US imports and travel to the US, it is likely to exacerbate general inflation in other countries.

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

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

The strong dollar also makes it harder for many developing countries to repay their debts, which are often denominated in US dollars.

“As a result, many countries will struggle to find an ever-increasing amount of local currency to repay 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, sovereign debt crisis, or all three, depending on the path chosen.

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