Sterling has not become an emerging market currency
And neither will it any time soon.
The idea that sterling has effectively become an emerging-market currency has become something of a common refrain in the four years since the Brexit vote.
Bloomberg's Sid Verma asked whether the pound was the "new Mexican peso" as early as October 2016, and the idea that it should be treated as an EM currency has been repeated many times since then. In September last year, then Bank of England Governor Mark Carney became the most high-profile person to join this gloomy chorus, pointing out that sterling volatility was at "emerging market levels", and that the currency had "decoupled" from its peers.
On Wednesday, it was the turn of a Bank of America analyst named Kamal Sharma, who said movements in the exchange rate had become "neurotic at best, unfathomable at worst" (we're not quite sure what that means either), and that the pound was now an emerging market currency in all but name. Apparently Brexit had turned the pound into a mirror of the "small and shrinking" UK economy.
So is there any truth to this? We'd argue no.
For a start, for sterling to really be an emerging market currency, wouldn't Britain have to be an emerging market? It seems an odd designation for the fifth- or sixth-biggest economy in the world, where income-per-capita is above $45,000 (almost four times above the threshold the World Bank sets to demarcate a "high-income country").
Ironically enough, those that argue that sterling is an "EM currency" are surely using very much the wrong term here. If the country is wilting away, surely "emerging" is the wrong word? Wouldn't shrivelling be better? Drooping? Submerging? A wilting market currency, perhaps? "Emerging" suggests that the country's economy is growing.
Second, just because implied volatility — a measure of the market's expectations for future gyrations in the exchange rate — is high, why should that suggest the pound is an EM currency? Clearly Brexit has been destabilising and has left the future unclear, and we all know that the one thing markets can't stand is uncertainty, so it doesn't seem very surprising that volatility — both actual and implied — is raised. Once some political stability has been reached, it seems likely that volatility will fall too.
Third, just because there is now less liquidity in the pound than some of its major peers like the dollar or euro, that again does not mean it is an EM currency. There's a difference between no longer being in the hallowed "G5" group of currencies — which it is not at all clear the pound has fallen out of permanently either — and being an emerging market currency. The Swedish krona isn't particularly liquid, but it's not considered EM.
We called up Stephen Jen, CEO of Eurizon SLJ, a hedge fund that specialises in emerging markets, to get his thoughts on the matter. He was pretty emphatic about the fact that sterling was very much not an EM currency in any way, shape or form, telling us (emphasis ours):
When you think of the uses of money — you have store of value, unit of account, medium of exchange — on all three measures it's very difficult to argue that sterling is not one of the prime, prime, currencies in the world. It's the number three reserve currency in the world, based on the global data, and it takes a lot of soft power for a currency to achieve that status. If you look at all the currencies that have a reserve status, they are issued by countries that have a lot of soft power. It's not just economic might — look at India and China, their currencies are nowhere on the list.
It's difficult to lose that soft power, which would include things like culture, rule of law, if it's perceived to be fair, if it operates without a lot of intervention or controls from the government, no surprises, and if it's governed by English law, which is well understood by the markets and the world — intangible and difficult-to-quantify practices of a country. All of these underpin the support for a currency such as sterling, and it's very difficult to supplant such a status.
In for a penny, in for a pound
We also called up Savvas Savouri, chief economist at Toscafund Asset Management, another hedge fund, to get his take. He told us the idea was nonsense, and that anyway he didn't necessarily feel that calling sterling an EM currency was pejorative, given that could just be interpreted as meaning that it was grossly undervalued. He told us (our emphasis, again):
This time next year the pound will be materially stronger, in all dimensions. One thing I've always remained steadfast on is that there will be an eleventh hour deal to avoid a no-deal Brexit… and the pound will then gap up — to 1.3 against the euro and 1.6 against the dollar. That's just using back-of-the envelope, econ 101 calculations.
Another characteristic of emerging markets (that is very much lacking in Britain's case) is that their businesses and governments often borrow in foreign currencies — usually the dollar or the euro — due to the lower cost of borrowing associated with assets denominated in leading currencies.
If you're located in the UK, it's difficult to see why you'd bother to do that, given that the government's cost of borrowing for five years is near record lows of -0.06 per cent hit on Thursday, and the cost of borrowing for ten years remains ultra low at around 0.15 per cent as of Friday morning.
It's also worth remembering that, as Jen points out, the UK has global reserve currency status, making up 5 per cent of official sector reserves, according to IMF data. That's more than the Swiss Franc, Australian dollar and Canadian dollar combined. The Fund's figures also show that the proportion of claims in sterling have actually risen since the vote in the middle of 2016.
Why does this matter? Because it lessens the risk that the cost of borrowing for the government will rise substantially any time soon.
All this is not to say that the pound's status hasn't been significantly affected by Brexit; clearly it has been, at least temporarily. But the UK is still one of the world's biggest and most influential economies, with leading universities, the English language, and high-quality cultural and manufacturing exports. Let's not get carried away; the Great British Peso will live to see another day.
Related links:
Pound is becoming an emerging market currency, says BofA analyst — FT
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