As sound as a pound?

Why did sterling rise in value after Standard & Poors put the UK on ‘negative watch’? Cynicus Economicus investigates.

What is the safest currency? For individuals and organisations, it is not as easy a question to answer as it once was.

For example, following the recent ‘negative watch’ placed on the UK by credit-reference agency Standard & Poors (S&P), a move that is often a precursor to a downgrade, the pound started to increase in value against the dollar and many other currencies. At first sight, this is the exact opposite of what might be expected.

The curious point here is that the potential downgrade for the UK appears to have prompted a re-evaluation of the US economy. Some have gone as far as to describe it as a ‘shot across the bows’ of the US authorities, pointing out that many of the criticisms S&P makes of the UK could equally be applied to the US.

Both countries, for example, run big budget and trade deficits, and have also embarked upon ‘quantitative easing’, which they have justified as a way to kick-start stalled credit markets, but which also looks like an excuse for printing money to meet yawning budget deficits.

Noble rot
In a previous article, I compared the UK to a faded eighteenth century aristocrat. He has been living the high life on the back of his creditors, while his estate has been in decline. He appears wealthy but is, in fact, flat broke. Yet his creditors still believe that he is monied on the basis of his long history of wealth.

Just as the UK might be seen in these terms, the same could be said of the US, but with an even greater belief in its even greater wealth. It is for this reason that the identification of the problems of the UK raised concerns about the US – the doubts about the minor aristocrat raises doubts about the great aristocrat.

The eighteenth-century analogy might be taken a step further, as this time in the UK was a period in which the epicentre of wealth and wealth generation started to shift from the hands of land-owning aristocrats into the hands of the new industrialists. In other words, it was a period of transition.

In the same way, we can see a shift of wealth away from the west, generally speaking – the US and Europe, as well as Japan – towards the emerging economies of the east. In both cases, the transition is not initially recognised and the perception of risk is misplaced, with the traditional roots of wealth regarded as a safer bet than the emerging sources of wealth.

However, those false perceptions of safety are starting to be challenged as the reality of the underlying risks in the western economies becomes clearer. Yet investors are only fleeing from one illusory place of safety to another.

As one commentator in The Daily Telegraph newspaper said, almost all of the OECD currencies are looking increasingly ‘ugly’ with ever-growing debts, falling output and an increasing use of printed money to support their economies. In the meantime, the perception of risk in the emerging economies remains, even though many of the economies appear to be built on more solid foundations.

Turbulent transition
Just as with the profligate eighteenth century aristocrats and the emerging industrialists, investors have failed to recognise the real risks that are emerging and where the great opportunities might lie. In failing to recognise this change, investors are moving from one high risk, advanced economy into another; from one major OECD currency into another, as each piece of bad news about each economy is absorbed.

What they fail to realise is that all of the advanced economies are at great risk during the transition and that there is no safe currency into which they might run. As such, it is possible to expect volatility in currencies as the reality of the transition for individual countries becomes more apparent, along with the implications for each currency.

With the movement of wealth from one economy to another being built upon false assumptions, the markets will continue to react in unpredictable ways. So, as we move through the transition into a new shape of the world economy, currency-related volatility can only grow.

This article was written by Cynicus Economicus, a former trade specialist based in China. He blogs at cynicuseconomicus.blogspot.com and can be contacted by emailing cynicuseconomicus@yahoo.com.