Sterling has remained strong against the euro for much of the currency union’s debt crisis, gaining an unlikely safe-haven status among European institutional investors who have shrugged off its very own homegrown recession, its widening trade deficit and fears about the sustainability of Her Majesty’s government’s weighty debt burden.
As a result, as European trading closed on Thursday it was 11.5 percent up on the year against the euro, at €1.273.
Safe havens only exist, of course, if investors are fleeing danger elsewhere. The euro has been the yin to sterling’s yang. Doubts over its strength and very survival have drawn to Britain investors who are reluctant to keep money in risky government bonds in the currency union that have fallen in value in local currency terms, and by even more when priced against the pound or dollar.
But how sustainable is the pound’s superhero status? The key question is what would happen to the pound if the euro zone crisis worsened considerably — would sterling actually, in the event, prove more of a safe haven than potential European rivals? Any answer must rest on looking at how the underlying U.K. economy would fare, relative to those of other potential safe havens.
Until recently, indisputably the biggest European rival to sterling as a refuge from euro zone troubles has been the Swiss franc — a safe haven for decades because of its country’s political and economic stability. Since 2011, the central bank’s aggressive defense of its cap against the euro of 1.20 francs has in theory set a mathematical limit to its safe-haven status, but this has not in fact destroyed such well-entrenched luster: Capital flows into the currency remained strong this year during times when the euro zone crisis took a turn for the worse. This reflects the belief of many investors that should an extremely severe euro crisis erupt, the Swiss National Bank would not be able to retain the cap in the face of overwhelming demand for Swiss francs.
There is, however, a potential underlying weakness in Switzerland’s safe-haven status: Comparing it with the U.K. and Sweden, another potential refuge for europhobes, it is the most exposed to the weak euro zone periphery. Exports are worth a hefty 54 percent of the economy according to the latest figures from the World Bank, reflecting the country’s small size, and 12 percent of these are to neighboring Italy and Spain, compared with only 7 percent for the U.K. and only 4 percent for Sweden (Sweden’s numbers do not include service exports, but these are a relatively unimportant part of Sweden’s overall international trade). Switzerland’s export network also leaves it more heavily exposed than Britain and Sweden to countries that could tip over into recession should the euro union crisis intensify, such as France and Austria. A serious recession in the euro zone would cut a swath through import demand from these states as well as from Italy, Spain and other countries in the periphery.
When it comes to the Swedish krona, Sweden’s low exposure to the euro zone periphery is an asset in its favor — as is its high exposure to the resilient northern euro zone countries including Germany. Although the krona has historically been primarily a play on global growth — rising when global equity markets rise, because of the export-focused nature of Swedish multinationals — robust domestic economic expansion and the absence of a fiscal deficit are pushing it towards safe-haven territory.
Although Britain is less exposed both to Italy and to Spain than Switzerland, as well as to states with uncertain economic prospects such as France, it cannot escape the fact that 42 percent of its exports are to the euro zone, based on an analysis of national figures — a proportion which dwarves that of the U.S. or the Brics (Brazil, Russia, India and China). Its banks have relatively little direct exposure to the more troubled peripheral countries such as Greece and Italy and have steadily reduced the limited exposure they once had.
However, chunks of its financial services sector, which accounts for 9 percent of output, would be at least partially frozen by a severe euro zone debt crisis. In 2011, fears over which European banks held how much toxic euro zone debt largely brought the unsecured lending market to a halt in London as well as Frankfurt and Paris. In short, U.K. gross domestic product would start to fall very heavily in the event of a fully fledged euro zone meltdown, because of hits to both exports and the financial system.
How far could the safe-haven economies afford to deterioriate without prompting a domestic debt crisis and how strong are the mechanisms that would stop them falling further than this?
Sweden’s economy has grown 2.3 percent over the past year, with the Swiss economy up 2.0 percent in the year to March. The U.K. economy has, by contrast, shrunk by 0.8 percent since mid-2011. Unlike Sweden and Switzerland, the country is therefore already in danger of a downward spiral, where shrinking output depresses tax revenue, forcing more government spending cuts, which depress the economy further.
Moreover, unlike Sweden and Switzerland, Britain lacks the fiscal and monetary elbow room to stimulate the domestic economy in reaction to a collapse in the euro zone. The Bank of England’s benchmark interest rate is already at the rock-bottom level of 0.5 percent, leaving no conventional monetary policy ammunition in the policy cupboard. Various unconventional measures, including quantitative easing, have failed to stop the economy from shrinking. The fiscal deficit is projected at 8.6 percent of GDP this year by the International Monetary Fund: lower than its 2009 peak of 10.4 percent but not low enough to practice Keynesian demand management without raising the eyebrows of government bond traders.
In conclusion, should the euro zone crisis grow considerably more severe, it is hard to see Britain avoiding a much deeper recession than its present one, given its high exposure to the currency union. Worryingly, it is difficult to see any policy levers that would break the economy’s fall. Given this, even the prop created by the Bank of England’s quantitative easing might no longer be enough to safeguard faith in a £1,218 billion ($1,505 billion) bond market supported by a shrinking economy and shrinking tax base. The pound has strengthened in response to the wall of money coming in to buy gilts, much of it from the euro zone. A sell-off in gilts could produce a rapid drop in sterling, toppling the pound from its safe-haven pedestal.
Sterling’s biggest safe-haven advantage may be the fact that, by some conventional measures of “fair value,” based on the actual relative prices and economic fundamentals of different countries rather than on as yet unrealized fears of a euro zone meltdown and other catastrophic events, it is rather a cheap safe haven compared with many of the alternatives. Jonathon Griggs, chief investment officer for currencies at J.P. Morgan Asset Management, thinks its recent rise against the euro has simply brought it up to fair value against the currency. By contrast, “the Scandinavian currencies have become overvalued on a relative basis.” Sterling’s modest valuation suggests that if it does drop from its pedestal, it may at least have less far to fall than if it had been considerably above fair value.