UK’s Sterling Crisis: Pound Weakens, Recession Awakens



As foreign investors reacted to the United Kingdom’s new prime leader and finance minister's proposals to cut taxes and increase expenditure to counter rising energy prices on early Monday (9/26), the British pound sterling collapsed to an all-time low. The currency's price dropped to £1 equalling US$1.0327, hitting an all time low, with investors expecting the pound to reach parity with the USD. Continuing a decline of roughly 21% since the beginning of the year, it is comparable to the currency crises that have characterized Britain's post-war history in terms of speed. With the GBP reaching its lowest in 37 years against the USD, reduction of value of assets throughout the UK, fuelled inflation by raising the cost of imports, and significantly higher interest rates are predicted to unfold - further stifling its GDP. Market pressure would likely persist in the upcoming days and weeks due to worries about government plans to implement significant tax cuts and spending increases during high inflation. Furthermore, the international response to the financial market turmoil was devastating in its criticism of the new government's policies, with the surprise and shock concentrated particularly on the chancellor's willingness to experiment with one of the most stable economies in the world. The UK continued to work to prevent a financial and economic crisis as the country's central bank began to take some measures.


The ongoing crises in the UK and Europe are mainly driven by the Russia-Ukraine conflict, which pushed energy and food prices far upward, leading to excessive inflation numbers. The ruling party on Friday rolled out a massive tax-cuts-and-spending package, namely mini-budget, that includes freezing taxes on corporations, dropping payroll taxes across the board, cutting the highest tax bracket, and temporarily subsidizing energy bills. The income tax rate would drop to 19% next year from the current 20%, while the top rate will drop to 40% from 45%, and a plan to increase the corporate tax rate to 25% was canceled, conveyed Truss’ finance minister, Kwasi Kwarteng. Furthermore, The International Monetary Fund (IMF) urged the government to reconsider its tax cuts. According to billionaire investor and famed economist Ray Dalio, the Truss’ administration is behaving like an emerging country despite being one of the most advanced economies in the world. Liz Truss made tax cuts the focal point of her agenda for government, which risks the emergence of several other economic, social, and political issues following the absurd policies. Truss’ significant move in her early term could lead to a political disaster causing even more chaos to the nation. According to Allan Monks, an economist at JPMorgan Chase & Co. in London, the market is unwilling to trust the Truss administration as it will deliver medium-term fiscal sustainability. Markets and investors also believe that Prime Minister Liz Truss is abandoning fiscal responsibility in pursuing sweeping tax cuts.


In response to the current ongoing issues, the Bank of England has taken emergency initiatives and intervened to protect the UK’s financial system. In an effort to stabilize and calm the market, according to Threadneedle Street, the Bank of England took urgent steps to purchase £65 billion in long-dated UK government bonds until 14 October as UK government bond yields have surged since Kwarteng’s mini-budget. Moreover, it delayed plans to sell £80 billion of government bonds built under its quantitative easing program. To tame the plunged pound, investors are betting the Bank to execute an emergency rate hike to shore up the UK's financial confidence. It is expected to raise rates to 6% by mid-2023 as the UK’s housing market has been analyzed to have a downfall. Aligned with the Bank of England's objectives to reach financial stability, it is also ready to restore market function and reduce any risks from contagion to credit conditions for UK households and businesses. Furthermore, the government must also take measures to diminish the crisis, including recalling parliament and abandoning the previous budget. With the government working in line with the Bank of England, it is hoped that these measures are able to support financial stability and tame the ongoing inflation.


Sources:

Bloomberg

CNBC

The Guardian


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