Following the revelation that Liz Truss would take over as prime minister of Britain, Deutsche Bank asserts that policy announcements in the upcoming weeks will be essential if the country is to avoid extreme macroeconomic events, particularly a balance of payments crisis.
Following a protracted struggle against former Finance Minister Rishi Sunak, Truss was declared the winner of the election to succeed Boris Johnson as the head of the ruling Conservative Party on Monday. Members of the Conservative Party voted 81,326 times for Truss and 60,399 times for Sunak.
The potential of a “sterling crisis” should not be underestimated, according to Deutsche Bank FX Strategist Shreyas Gopal, even if sterling was slightly higher versus the dollar on Monday afternoon, trading just below $1.15.
Sterling needs significant capital inflows supported by rising investor confidence and declining inflation expectations because the current account deficit is already at record highs. The contrary, though, is taking place,” Deutsche Bank wrote in a note on Monday.
“The U.K. is struggling with the highest G10 inflation rate and a dimming prospect for growth. An even greater increase in inflation expectations and, at the extreme, the formation of fiscal dominance might result from a big, unfunded, and untargeted fiscal expansion coupled with prospective modifications to the Bank of England’s mandate.
Truss blamed the Bank of England and its Governor Andrew Bailey for allowing inflation to surge to 40-year highs during her leadership campaign and is allegedly exploring a review of the Bank’s mission.
The Northern Ireland protocol, a crucial component of the post-Brexit divorce agreement between the UK and the European Union, has also been recommended by her. This approach is likely to elicit reprisal from the bloc.
According to Gopal, more trade policy uncertainty will further cloud the macroeconomic picture and undermine investor confidence
“At the same time as unusually high foreign outflows, the risk premium on UK gilts has already begun to rise. This tendency might develop into a self-fulfilling balance of payments crisis where foreigners will refuse to fund the U.K. external deficit if investor confidence continues to decline, he said.
To bring the U.K. deficit back to its 10-year normal, according to Deutsche Bank, trade-weighted sterling, a measure of the pound’s value versus a chosen group of currencies, would need to decrease by another 15%.
According to Gopal, “a balance of payments funding crisis may sound extreme, but it is not unprecedented: a combination of strong fiscal spending, severe energy shock, and a decline in sterling finally led in the U.K. needing an IMF loan in the mid 1970s.”
Although the UK still has some important lines of defence in place against a sudden stop, we are concerned still because the dangers are increasing.