Free Fall of Pound Sterling

resr 5paisa Research Team

Last Updated: 15th December 2022 - 11:25 am

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The value of the pound dropped as low as $1.084 following the House of Commons' announcement of a tax-cut programme. The value of the pound in relation to the dollar has plummeted this year, hitting record lows this month.

The government announced a package of growth-oriented policies on Friday that included a combination of tax breaks and business investment incentives.

According to Foley, the pound is vulnerable to a downward revision because the U.K. has a record debt-to-GDP ratio and markets are "clearly very doubtful of the ability of this government to manage debt.

The UK's current account deficit, which is comprised of the trade balance, net income from foreign investment, and transfers, had already increased this year to a record level. This deficit, which is being exacerbated by the increase in the price of imported energy, is driving the pound toward levels where UK assets are once more appealing to foreign investors.

What is a currency crisis?

When the value of the pound (the local currency) against rival currencies (the foreign currencies) falls sharply. Uncertainty results from a sudden and significant decline in the value of the pound, which disrupts the plans of UK companies that import and export goods. They anticipated paying a specific amount for imports and receiving a specific price for the goods and services they export. When the currency depreciates, everything changes. The price of importing goods from abroad increases if the value of the pound declines.

For the UK, what does it mean?

When purchasing goods from abroad, UK consumers will pay more, and travelling abroad to the US or other countries that use the US dollar will cost them more money due to the weaker pound.

One of the main products that Britain imports is oil, which is traded on global commodity markets for dollars. Fueling up a car with diesel or gasoline will cost more if the pound is weak. Dollars are also used to price gas.

Additionally, more than half of the food consumed in the UK is imported, raising the price of everything from artichokes to bananas.

Why is it taking place?

Truss wants to proceed with tax cuts in the coming year, paying for them with higher borrowing from the government. She thinks the extra funds will be used to finance investments and raise productivity in the UK. However, detractors claim that placing more cash in people's hands will boost demand and raise inflation. Fears of inflation exploding once more have increased in response to Kwarteng's weekend promise to cut taxes even more in the coming year.

Investors are also worried that increased borrowing won't be offset by faster growth and increased tax revenues, leaving the UK with longer-term debt problems.

The strength of the dollar, which has increased as the US central bank, the Federal Reserve, has been aggressively raising rates, is also a factor in the weakness of the pound. However, following the announcement of the tax cuts, the sell-off in the pound has greatly increased.

The UK government's decision to enact significant tax cuts that will be financed by increased government borrowing has apparently caused panic among international investors. Due to the tax cuts, households are anticipated to spend more money, which will raise inflation by increasing demand for goods and services. The weekend promise by Kwasi Kwarteng to cut taxes even more in the coming year has only increased worries that inflation will spike once more.

Rishi Sunak, the previous chancellor, had promised to reduce the UK's overall debt as well as the annual spending deficit. Both measures are currently moving in the wrong direction.

The dollar's strength, which has increased as the US Federal Reserve has been raising interest rates aggressively, is one factor contributing to the pound's weakness.

What steps is the UK government taking in response?

The Bank of England is likely to take the next step, which could result in an increase in interest rates that is greater than initially anticipated. Before its upcoming policy decision on November 3rd, the Bank could announce an emergency increase.

Officials promised to "make a full assessment" of the impact of the government's announcements on demand, inflation, and the value of the pound at their upcoming scheduled meeting and take appropriate action, according to a statement released on Monday.

Higher interest rates tend to boost the value of the pound and draw savings deposits to the UK. They do, however, also make borrowing more expensive for both households and businesses.

Governments have in the past attempted to reassure markets by announcing their plans to reduce public spending budgets in order to balance the books.

What impact will this have on other nations?

It lowers the cost of goods, services, and assets in the UK. It's possible that foreign investors will go on a spending binge to scoop up assets that would have otherwise cost much more to purchase. Additionally, visitors to the UK will have more money to spend and can benefit from the favourable exchange rate.

Investors who previously purchased UK assets will see a decline in value. In response, some investors will insist that their investment returns be paid in US dollars. Others will sell the asset, particularly if they think the currency will continue to decline.

The Way to Parity:

Following the UK government's announcement of new tax cuts, the pound fell, adding to investors' and economists' worries that the debt of the four-nation bloc will rise to unaffordable levels and drive up inflation. Additionally, it follows the Bank of England's 50 basis-point rate hike, which was smaller than the US Federal Reserve's 75 basis-point increases.

The government intends to use billions of pounds worth of debt to pay for its tax cuts. The financing mandate for 2022–2023 will increase to 234 billion pounds thanks to plans by the UK Debt Management Office to raise an additional 72 billion pounds before next April.

The tax cuts, according to UK economist Sanjay Raja, are "raising the risk of a near-term balance of payment crisis" and have increased medium-term inflationary pressures.

Citi analyst Vasileios Gkionakis concurred that the action will bring the sterling to parity with the US dollar, noting,

"With such a deteriorating economic backdrop, the UK will find it increasingly challenging to finance this deficit; eventually, a much lower pound exchange rate will result."

The effects of the pound's parity with the dollar largely depend on how and where money is being spent. There were winners and losers when the euro and the dollar were at parity, and the same thing can be predicted if the value of the pound is equal to that of the dollar.

The change in the exchange rate will undoubtedly be apparent to traders and exporters. Lower import costs in the US would result from a stronger currency, which might help to contain inflation. For the UK, the opposite might be expected since prior purchases would have allowed for inferior goods if the two currencies were at parity.

Therefore, if US businesses operating in the UK bring back earnings in pounds to the US, those businesses' revenue will decrease. However, the exchange rate becomes less of a problem if earnings are used in the UK.

Four stocks were impacted by the drop in the pound sterling

1. Motherson Sumi:

The Motherson Group's flagship company, Samvardhana Motherson International Limited, was founded in 1986 as a joint venture with Sumitomo Wiring Systems (Japan). The company's main business is the production and sale of parts to original equipment manufacturers in the automotive industry.

% Revenue from UK / Europe = 56%
Total revenue FY22= Rs. 64,031.66 Cr
Thus, Revenue from UK / Europe = Rs. 35,857.72 Cr
Return on Capital Employed = 8.44%
Return on Equity = 5.27%
Though the current operating profit margin of the company is 2.4%.

Motherson is a well-known global supplier to the automotive industry. As we can see above, the UK and Europe account for nearly 56% of its revenue. Motherson Sumi could be impacted by the decline in the value of the pound as a result of its increased exposure to the UK and European markets (Downgrade:-Estimated price Rs 106).

2. Balkrishna Industries:

Off-Highway Tires (OHT) are produced and sold by Balkrishna Industries in the specialised markets of Agricultural, Industrial & Construction, Earthmovers & Port, Mining, Forestry, Lawn & Garden, and All Terrain Vehicles (ATV).

% Revenue from UK / Europe = 52%
Total revenue TTM = Rs. 8,295.12 Cr
Thus, Revenue from UK / Europe = Rs. 4,282.73 Cr
Return on Capital Employed = 24%
Return on Equity = 17.22%
The current operating profit margin of the company is 18.73%.
Due to its diversified portfolio and exposure to Europe, it is one of the best companies in the tyre sector and could be impacted by the decline in the value of the pound (Downgrade:- Estimated price Rs 1,790).

3. Tata Motors:

Leading global manufacturer of automobiles is Tata Motors. A wide variety of cars, sports utility vehicles, trucks, buses, and defence vehicles are included in its varied portfolio.

% Revenue from UK / Europe = 33%
Total revenue TTM = Rs. 2,81,507.25 Cr 
Thus, Revenue from UK / Europe = Rs. 33,228.52 Cr
Return on Capital Employed = 1.40%
Return on Equity = -22.3%
Despite the fact that the company's current operating profit margin is 9%.

Tata Motors has a wide range of affiliates and subsidiaries around the world, including Jaguar Land Rover in the UK. Due to exposure from the UK/European market, it might suffer.

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Disclaimer: Investment/Trading is subject to market risk, past performance doesn’t guarantee future performance. The risk of trading/investment loss in securities markets can be substantial. Also, the above report is compiled from data available on public platforms.

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