Sterling crisis: what are the historical precedents?

The sterling exchange rate has been sliding during 2022, particularly against a strong US dollar. On 1 January, £1 would have bought $1.35, compared with just $1.20 on 21 July (Investing.com).

Figure 1: GBP to US dollar exchange rate

Source: Investing.com

Might this weakness – in a context of high inflation and low growth – be pointing towards a future crisis of the currency? That is hard to judge. Sterling weakness is no longer resisted by UK authorities as it was in the 20^th century, undermining the idea of a sterling crisis.

But examining relevant elements of past sterling crises can still help us to understand what is currently happening and what might happen going forward.

What is a currency crisis?

There are many reasons why people and organisations buy and sell pounds, say, for other currencies. Such ‘business as usual’ foreign exchange transactions – for example to pay for imports – take place all the time.

In a currency crisis, there is unusually large dealing activity by speculators, who sell pounds in expectation of making a profit, by buying them back on a later date, at a lower exchange rate. Anyone can be a speculator, whether it be a business, individual or government agency. They are motivated by making a profit or avoiding a loss.

While speculation in foreign exchange takes place constantly, the distinguishing features of a currency crisis are the widespread expectations of the speculators, and the scale and direction of their speculation: to sell the currency.  

A currency crisis is therefore defined as a ‘speculative attack’ on the currency, and it results in either a large, discrete decline in the exchange rate, or strong countervailing policy action to overcome the currency pressure. It can be measured with hindsight by calculating a weighted currency pressure index, measuring unusual changes in the exchange rate, interest rates and international reserves (Eichengreen et al, 1994).

More simply, it can be defined as a minimum threshold decline in the exchange rate, say, by 15% or 25% over a short period (Reinhart and Rogoff, 2009; Frankel and Rose, 1996).

A currency pressure index is hard to apply historically to the UK, where published reserves and key interest rates were frequently ‘massaged’ by the authorities (Capie, 2010; Naef, 2021). The effective decline in sterling against trading partners during acknowledged crises over the last 100 years has always been less than 25% (see Table 1).

Movement against the US dollar has sometimes been greater, but the United States has a current weight of only 20% in sterling’s effective exchange rate index calculated by the Bank of England. Europe’s weight is 55%, while that of China/Hong Kong is 12%.

Table 1: Past crises

Time period	Crisis	Decline vs USD / effective	Resisted?	Banking crisis	Political crisis
Sept-Dec 1931	Sep 1931 Forced off gold standard	-33% / -20%	Yes	Yes	Yes
Aug-Sept 1939	Eve of WW2	-14% / na	Yes	No	No
Jul-Aug 1947	Convertibility	-	Yes	No	No
May-Sept 1949	Sep 1949 Realignment	-33% / -9%	Yes	No	No
Jun 1951 - Jul 1952	Korean war boom	-	Yes	No	No
Apr-Oct 1955	Floating exchange rate debate	-	Yes	No	No
May-Dec 1956	Suez	-	Yes	No	No
Apr-Sep 1957	-	-	Yes	No	No
Jan-Jul 1961	-	-	Yes	No	No
Jul 1964 - Jan 1965	-	-	Yes	No	No
May-Aug 1965	-	-	Yes	No	No
Jan-Sep 1966	-	-	Yes	No	No
Apr-Nov 1967	Nov 1967 devaluation	-14% / -14%	Yes	No	No
Jun-Jul 1972	Jun 1972 forced from EEC snake, sterling floats	-8% / -8%	(Yes)	No	No
Mar 1975 - Oct 1976	Slide leading to IMF loan	-36% / -23%	(Yes)	(Secondary)	No
Jan-Sep 1981	Slide from strong pound	-26% / -18%	(Yes)	No	No
Dec 1985 - Oct 1986	Lawson slide, oil price fall	-4% / -19%	(Yes)	No	No
Sep 1992 - Feb 1993	Sep 1992 forced from ERM	-29% / -18%	(Yes)	No	No
Sep-Dec 2008	Sep 2008 Lehman collapse, global financial crisis	-21% / -19%	No	Yes	No
Jun-Oct 2016	June 2016 Brexit referendum	-16% / -16%	No	No	(No)

Sources: Bank of England daily sterling-dollar exchange rates and effective exchange rate indices; Burk and Cairncross, 1992; Cairncross, 1985; Cairncross and Eichengreen, 1983; Cairncross, 1996; Eichengreen, 1995; Hirsch, 1965; Kennedy, 2018; Redmond, 1980; Schenk, 2010; Stephens, 1997.

What makes a currency crisis?   

Theories of currency crises seek to explain the reasons why a successful speculative attack might occur. They focus on inconsistent macroeconomic policies (for example, the crises in Latin America in the 1980s), self-fulfilling crises caused by speculators perceiving policy dilemmas (such as the 1992 European exchange rate mechanism, ERM, crisis) or financial fragility in the banking system or wider economy (for example, the 1997 Asian crisis) (Glick and Hutchison, 2011).

Historic sterling crises have usually been explained as the first type, by government policies that are inconsistent with the prevailing exchange rate. For instance, the sterling crises of the 1960s have been attributed to fiscal deficits leading to excessive public-sector borrowing. The expansion of domestic demand increased the volume of imports and, through higher wage costs, adversely affected the competitiveness of exports. This produced strains in the balance of payments. The Bank of England then did not tighten domestic monetary conditions sufficiently to counteract the resulting loss of reserves (Capie, 2010).

By contrast, banking weakness played a major role only in the significant cases of the UK leaving the gold standard in September 1931 (Accominotti, 2012) and the global financial crisis of 2007-09 (Laeven and Valencia, 2010).

Such ‘twin crises’ – a banking and a currency crisis each exacerbating the other – can have some of the worst consequences for an economy (Kaminsky and Reinhart, 1999). While the British banking system is stronger than in 2007, low interest rates and high levels of debt make firms and households vulnerable to rising interest rates.    

The 1992 ERM crisis is usually presented as a self-fulfilling crisis (further details in the box below). Speculators perceived that the government would not accept the deflationary measures, and unemployment consequences, needed to defeat them (Eichengreen et al, 1994). In this case, while inconsistent macroeconomic policies led inexorably to devaluation, in a self-fulfilling crisis devaluation only happens if speculators make it happen.

These types of crises are by definition hard to spot because common early warning signals, such as a rise in the real exchange rate (prices of UK goods becoming uncompetitive internationally), are not necessarily present. (For early warning signals see Reinhart and Rogoff, 2009; Glick and Hutchison, 2011).

The ERM crisis The UK’s dramatic exit from the ERM on Black Wednesday, 16 September 1992, was a costly national humiliation and demonstrated how powerful speculators had become in foreign exchange markets. It also shows the importance of the international context. For 20 years, the European community had been operating currency peg schemes, designed to keep member currencies stable against each other. But after an embarrassing early exit from the European ‘snake’ in 1972, the UK avoided them. The government’s decision to join the ERM in October 1990 had mainly a counter-inflationary purpose, since its anchor currency was the low-inflation Deutschmark. But this late entry also coincided with the reunification of East and West Germany. By summer 1992, Germany’s independent central bank was keeping its own interest rates high in order to combat the domestic inflationary consequences. Meanwhile, the UK was in recession, with its key short-term interest rate at 10%, and there was concern that the recession could become a slump. In other words, the UK was not – on this occasion – following inappropriately loose fiscal and monetary policy. What was needed was an orderly realignment of currencies with an increase in the value of the Deutschmark against other leading participants. Most historical accounts indicate that this was diplomatically feasible within the ERM. But the British government boxed itself into a corner. The Chancellor Norman Lamont refused to devalue unless France did so. He also signalled that the government had little stomach for an increase in interest rates given the state of the economy. And his rhetoric indicated that he would use massive intervention in the currency markets to defend the peg and defeat the speculators. This was a further invitation to speculators, such as the Hungarian financier George Soros, who could see that an increased volume of intervention by the British, French and German central banks would allow even larger opposing bets to be made at a vulnerable exchange rate, creating the opportunity for an increased volume of profits. The battle was lost within a few days after the Bank of England’s foreign exchange reserves were exhausted. Black Wednesday itself proved the impotence of the government’s efforts, culminating in a decision to abandon the ERM entirely. In the following months, sterling continued to drift downwards. After its unsuccessful experiments with monetarism and exchange rate targeting, the British government came to concentrate its counter-inflation efforts on targeting inflation directly. (See Roberts et al, 2017; Schenk, 2010; Stephens, 1997).

The power of speculators increased significantly with the growth of international capital flows from the 1990s (Lane and Milesi-Ferretti, 2007). But policy dilemmas and constraints on government action are also nothing new and have been a feature of most sterling crises since 1931. Unemployment was a particular government concern in 1931, 1972, 1992 and the global financial crisis of 2007-09.

The exchange rate policy context

Implicit in these theoretical ideas is the existence of an exchange rate policy – resisting the speculative pressure – and a monetary regime, such as a fixed or pegged exchange rate. Resistance means that the government makes policy more consistent by increasing interest rates, reducing government spending and raising taxes. Or it employs its international reserves, intervenes in the spot and forward exchange markets and borrows reserves from other countries, hoping to see off the speculators.

Under fixed exchange rate regimes, the interwar gold standard (1925-31) and Bretton Woods (1946-71), the sterling devaluations of 1931, 1949 and 1967 were fiercely resisted, and the capitulation was accordingly traumatic (Cairncross and Eichengreen, 1983).

Under pegged or managed floating regimes, the depreciations of 1972, 1976 and 1992 were also resisted for a time, with international borrowing, but with less commitment (Schenk, 2010). This century, reflecting the reality of large capital flows and the UK’s limited international reserves, sterling has been floating freely.

The sterling exchange rate declines of 2008 and 2016 were not resisted and so did not attract much adverse comment. Nicholas Macpherson argues in the Financial Times that UK citizens should be concerned about sterling weakness, which increases inflation and, post-Brexit, may be becoming less effective at reducing trade deficits, but that UK politicians think they can be indifferent to it.

Fundamentals, the current and capital accounts

Fundamental international changes in capital, human capital, production and productivity lead currencies to fluctuate over time. The long-term trend of sterling has been downward and some devaluations – for example, 1931 and 1949 – partly reflected the consequences of world wars.

In such devaluations, there is ‘reason to doubt whether things would have gone better in the long run…if…devaluation had been delayed or avoided altogether’ (Cairncross and Eichengreen, 1983). The fundamentals are seen in the balance of payments, where problems can lie either in the current or capital accounts, with the latter playing a large role in all the sterling crises listed in Table 1.

Between the 1949 devaluation and the 1972 float, a period littered with sterling crises, the UK had a current account surplus more often than a deficit. Current account deficits also tended to be small in relation to GDP – for example, 1% in the crisis year 1964 (Mitchell, 1988).

But policy-makers argued that UK current account surpluses were simply not large enough given sterling’s use as a reserve currency by the ‘sterling area’, mainly comprising Commonwealth countries, and UK capital exports to those countries.

In 1965, 89% of the sterling area’s foreign exchange reserves were still held in sterling. This meant that sterling’s fortunes rested on the balance of payments of the wider sterling area, not just the UK. Some sterling crises, such as those in 1952 or 1957, coincided with heavy spending of sterling reserves by Australia or India (Kennedy, 2018).

Sterling’s weakness between 1964 and 1976 is also partly attributable to the disintegration of the sterling area, as sterling-holding countries – from Burma in 1964 to Nigeria in 1975-76 – sold sterling for other currencies (De Bromhead et al, 2022; Schenk, 2010).

Today, sterling is still a minor reserve currency, accounting for about 5% of known global foreign exchange reserves (International Monetary Fund). At the same time, the UK has a large current account deficit running in 2022 at more than 7% of GDP, making it reliant on capital inflows (Office for National Statistics).

Monetary and fiscal policy adjustment

Under fixed and pegged exchange rate regimes, the central bank first perceives currency pressure through a loss of reserves. To halt this and stabilise the exchanges, UK authorities usually increased short-term interest rates and tightened lending conditions. The action that governments usually found most difficult and controversial was to reduce public spending (Cairncross and Eichengreen, 1983; Capie, 2010).

In the 30 years following the Second World War, burdened by post-war debt, UK governments were concerned about the country’s slower growth relative to peers. They often delayed taking corrective action, leading to speculative pressure on reserves and sudden interest rate hikes coinciding with crises (see Table 1). The reserve signals were also made more confusing by payments in the wider sterling area, further delaying fiscal adjustment – for example in 1960 and 1964.

The overall result was a pattern of ‘stop-go’ in UK economic activity (Brittan, 1971). Policy-makers even thought that this might be the reason for the UK’s relative underperformance and that it would be better to ignore the signals. In 1963-64 and 1972-73, governments consciously decided to ‘go for growth’. This led to severe pressure on sterling in October-November 1964, and high inflation in 1974-75, after the price of oil more than doubled in late 1973 (Brittan, 1971; Cairncross, 1996).

As seen in past inflationary episodes, persistently high inflation relative to other countries is accompanied by currency depreciation (Reinhart and Rogoff, 2009). To defeat inflation, people’s expectations must be anchored by credible monetary and fiscal policy (Sargent, 1982).

In the 1980s, monetary policy and a strong pound were used forcefully to bear down on inflation, to the cost of the UK’s manufacturing sector (Stephens, 1997). Since 1997, the setting of interest rates has been delegated to the Bank of England’s Monetary Policy Committee (MPC).

But an independent agency targeting 2% inflation two to three years in the future may still suffer from forecasting errors and biases, such as being more concerned about today’s weak growth than its above-target inflation.

Changes in expectations

The context for sterling today is very different from that which prevailed during the sterling crises of the 20^th century. The days of exchange rate intervention and the sterling area are long past.

Nevertheless, sterling’s effective exchange rate could be vulnerable to changes in expectations about the UK triggered by, for example, fiscal policies lacking credibility or adverse new information.

The government is facing difficult decisions about how to navigate the cost of living crisis. Inflations and recessions can lead to social and political conflict, which was notable in 1931 and 1972-79. A new prime minister may be tempted to ‘go for growth’, repeating the approach of 1963-64 and 1972-73. And new information may emerge about the likely longer-term effects of Brexit on UK exports, investment and growth.

Even small changes in long-term expectations can have a large impact on the exchange rate, as currency markets discount the future and recalculate its present value.  

Where can I find out more?

• The British should stop being so relaxed about the weak pound: Financial Times article by Nicholas Macpherson
• Financial Stability Report: Bank of England, July 2022
• Market Participants Survey results: Bank of England, June 2022
• World economic outlook: International Monetary Fund, April 2022
• OECD economic outlook: June 2022
• Annual economic report: Bank for International Settlements

Who are experts on this question?

• Currency crises: Olivier Accominotti, Guillermo Calvo, Barry Eichengreen, Jeffrey Frankel, Michael Hutchison, Graciela Kaminsky, Paul Krugman, Maurice Obstfeld, Carmen Reinhart, Kenneth Rogoff, Andrew Rose
• British economic policy: Forrest Capie, Nick Crafts, Barry Eichengreen, Nicholas Macpherson, Roger Middleton, Scott Newton, Catherine Schenk, Jim Tomlinson
• History of sterling: Maylis Avaro, Benjamin Cohen, Barry Eichengreen, Francis Kennedy, Catherine Schenk, John Singleton

Author: Francis Kennedy

Picture by VM Studio on iStock