Pound Could Still Fall Deeply if Scotland Seeks Independence and Sterling Loses Reserve Status

Yet more risks lie on the post-Brexit horizon, according to a recent report from Dutch lender ING; these include another Scottish referendum on independence, sterling losing its Reserve status and difficulties with the UK covering its current account deficit

Whilst analysts are preoccupied with whether or not the Bank of England (BOE) will cut interest rates and how and by when the UK divorces the EU, rating agencies have highlighted three more areas of concern, which could spell even more market volatility if they materialise.

Indeed, according to ING’s FX Strategist Viraj Patel, the pound to dollar rate - which is currently trading at 1.3232 - could fall to as low as 1.20 in time, due to these new risks, which, it is argued  were ‘spawned’ from the UK’s decision to leave the EU.

“Rating agencies have identified three broad areas of concern that risk eliciting another UK credit rating downgrade: (i) greater likelihood of a Scottish independence; (ii) difficulties in financing the current account deficit; and (iii) GBP losing its reserve currency status. Were these risks to crystallise, and the UK’s credit rating cut again, then we estimate that GBP/USD could fall to 1.20.” Comment’s the strategist in a recent note.

The first concern, ‘Scottish Independence’, comes as a result of the majority of Scots voting to remain in the EU, as compared to the majority of English voters.

This, it could be argued, gives them a valid reason to resist Scotland leaving the EU, which would be strong grounds to hold another referendum on independence.

In the last Scottish referendum, the pound fell steeply before the vote as the polls were too close to call, and even showed the leavers ahead sometimes even though the result was to ‘Remain’.

The sell-off came from uncertainty about the future which lessened investment, including foreign investment and delayed projects with a Scottish association.

It was also thought the UK would suffer from the loss of North Sea Oil reserves.

If there was another Scottish referendum, the pound would weaken for the same reasons plus there would also be those created by Brexit.

This might well push rating’s agencies into considering a down-grade of the Uk’s AA credit rating.

Pound's reserve status in question

The second major risk is that the pound will lose its status as a reserve currency.

Sterling is held in central banks all over the world and accounts for 4.8% of the total of the world’s reserve currency reserves, however, if its share were to fall to only 3.0% that might lead to it losing reserve status, which would in turn potentially trigger a credit rating down-grade.

“S&P (a credit rating agency) have specified that were GBP’s share of global FX reserves to fall below 3%, then GBP may lose its reserve currency status. IMF COFER data puts GBP’s share at 4.8% as of 1Q16 (2Q data due 30 Sep).” Says Patel.

The pound’s status as a reserve currency is heavily dependent on London being a global financial centre.

There is a possibility Brexit could influence how large a financial centre London is, particularly in relation to euro clearing, which there are plans to force London to give up now it has left the EU, this could impact on whether the pound retained reserve status. Euro-clearing accounts for a sizeable chunk of the City’s businesses.

Another issue faced by financial services in the capital is the possible loss of the EU passport which allows them sell and market their products all over the EU.

Without the passport they would find it much harder for them to sell products and services in the EU, companies that wished to would have a harder time justifying operating from London.

Other options for financial companies, might include Paris, Frankfurt and English-speaking Dublin.

Foreign Investment Flows

The third and final risk on the horizon is already known by many analysts, and is the fear that, as a result of Brexit, foreign investment will dry up, which will impact negatively on sterling because of the fall in demand for the currency.

It will also be a bad sign for the economy as it will show the country is spending more than it is getting from either exports or investment.

Previously inbound flows from foreign capital helped offset the massive difference in the amount the UK imports compared to the smaller amount it exports, however following Brexit:

“Uncertainty over Britain’s future access to Europe’s single market may deter inward investment while Brexit negotiations occur (with FDI inflows having primarily financed the current account deficit in recent years).” States the Strategist.

If the UK were to experience any of these risks Patel goes on to describe how they would affect the economy:

“Were any of these risks to crystallise, then we would expect pressure for another UK rating downgrade to mount….

“Our analysis shows that this may lead to a further 8-10% decline in GBP/USD.

“We would expect GBP/USD to decline to 1.20 should risks of a UK rating downgrade intensify.”

Possibility of rebound in exports due to fall in pound – Loynes’s “Goldilocks depreciation”

One antidote to the UK’s widening Current Account (CA) deficit, is that as a result of the pound’s depreciation UK exports will be cheaper to foreign buyers, making them more attractive.

This should increase sales of UK exports, helping to offset the fall in foreign investment, and potentially resisting a widening in the CA black hole.

In a recent article by the London-based advisory service Capital Economics, Economist Jonathan Loynes argues, for example, that assuming sterling’s fall is gentle, it could create just the right combination of export price enhancement without undue inflation (from rises in the price of imports).