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How to get the exchange rate lower

Roger Bootle and John Mills, September 2016

Real Sterling Crisis front coverSuppose that the authorities decide that the exchange rate should be lower. What could they do to bring this about? Possible policies fall into five broad types:

  • Changes to the macroeconomic policy mix, e.g. running a tighter fiscal policy in order to make a possible looser monetary policy (i.e. lower interest rates and/or more quantitative easing (QE) than otherwise);
  • Prudential policy tools, including reserve requirements and capital requirements;
  • Intervention on the foreign exchanges;
  • Talk and guidance, perhaps even extending to the publication of targets;
  • Micro policies designed to make UK assets less attractive to overseas investors.

In principle, of course, it would also be possible to deploy capital controls, and many countries do – including China. But capital controls are distortionary, as well as being against our undertakings to both the EU and the G7. They don’t have any practical appeal for a country like the UK. Accordingly, we do not include them in the list of five types of instrument, described above.

1. The Macroeconomic Policy Mix

In principle, fiscal policy could provide the extra policy instrument. In theory it would be possible to use changes in fiscal policy to constrain the growth of aggregate demand to the growth of productive capacity and therefore forestall and/or correct a movement of inflation away from the target.

In practice, though, fiscal fine tuning is not a viable proposition. It is not economically desirable or politically attractive to make short-term adjustments to the fiscal balance, through either tax changes or changes to planned expenditure. Nor do short-term fiscal adjustments have predictable effects on aggregate demand. Nevertheless, it is a viable proposition to set fiscal policy on a course that would facilitate the maintenance of a competitive exchange rate.

Running a tight fiscal policy would certainly help to establish and sustain a policy of low interest rates without necessarily landing the country with an inflation problem. But it does not really constitute a second policy instrument that would allow the authorities to pursue two policy objectives. Firstly, in most countries, including the UK, fiscal policy is set with regard to another objective, namely reducing the ratio of government debt to GDP on a path that is deemed optimal, balancing the need to reduce the total, and retain bond market confidence, against the need to avoid delivering a shock to aggregate demand through tightening too quickly.

In the UK there has been a fervent debate about the appropriate degree of fiscal tightening, with critics of the government arguing that it is planning to tighten too much. But in this debate scant regard has been paid to the exchange rate. It deserves much more attention.

Some of the criticism of the government’s fiscal stance derives from the idea that there is considerable spare capacity in the economy and that the tight fiscal policy thereby leads to unnecessary waste of resources. This may or may not be true but what matters for policy is what the Bank of England believes.

If the Bank believes that there is no margin of unused capacity then, if fiscal policy were to be looser, the Bank would set interest rates above where they would otherwise have been. Other things equal, that would tend to increase the exchange rate for sterling, with the usual adverse consequences for our competitiveness and hence for the current account.

Even without the assumption of unused resources, of course, the critics of current fiscal policy may have a point with regard to with the unfair/unjust/unnecessary/inefficient squeeze on the public sector relative to what is going on in the private sector. In particular, they could point to the squeeze on public investment.

But without the unused resources assumption they should surely take account of the potential damage to our current account that a looser fiscal policy would imply, recognising that a larger current account deficit would imply a worsened national wealth position which would offset at least some of the gain from higher public investment.

So what role can fiscal policy play with regard to management of the UK exchange rate? Taking it as a given that the position of public investment should be protected, concern to improve the current account position argues for a tighter fiscal stance. In ordinary conditions this would be demanding enough politically and it is so now. But in current circumstances at least tighter policy fits in with the objective of reducing the ratio of government debt to GDP. Operating a tighter policy would result in a lower ratio being achieved, or the same ratio being achieved sooner.

In this regard, it is important to recognise a potential change in circumstances. When interest rates were at rock bottom (and the authorities appear to have regarded 0.5% as rock bottom for the UK) and there were doubts about the wisdom and/or effectiveness of more QE, a tighter fiscal policy would not have delivered looser monetary policy, and therefore would not have helped to sustain a weaker exchange rate. These have been the conditions for the last several years.

Very low rates are now likely to continue for an extended period. But thereafter we will enter a period when interest rates are set to rise. In these circumstances, a tighter fiscal policy could put back a rise in rates, and continue to keep rates lower than they would have been under the original fiscal policy. They could also justify more QE, whether this is conducted across the exchanges (foreign exchange intervention) or not. (See below.)

2. Prudential policy tools

In practice, in the UK there has over recent years been some amelioration of potential policy conflict through the development of a prudential policy toolkit. This has assuredly not been developed in order to allow policy to pay explicit regard to the exchange rate but rather to allow the central bank to pursue objectives for both the inflation rate and financial stability.

In principle, this extra set of tools would be available to help manage the exchange rate. For instance, suppose that a burgeoning inflation problem seemed to require higher interest rates to head it off; it might be possible to address this by deploying a tightening of prudential policy without requiring higher interest rates, which might threaten to send the pound higher on the exchanges.

But, of course, if prudential policy is there to address concerns of financial stability, it cannot be used simultaneously, except by happy coincidence, to help manage the exchange rate. So another instrument is needed.

3. Foreign exchange intervention

Foreign exchange intervention has acquired a bad name – along with the policy of exchange rate management. There are good reasons for this. Usually, intervention has been employed to stop a currency from falling. This involves selling foreign currency and buying domestic currency.

This has a clear limitation. The domestic monetary authorities can run out of supplies of foreign currency to sell (the foreign exchange reserves) and their access to further supplies through borrowing will also be limited.

There are countless examples of countries finding it impossible to hold the exchange rate up against apparently limitless waves of selling. Perhaps the best example is when the Bank of England tried and failed to keep the pound in the European Exchange Rate Mechanism (ERM) in September 1992.

But the position is different when central banks are trying to keep their currencies down. In this case they have to sell domestic currency and buy foreign currency. In principle, there is no limit to the amount of domestic currency that they can issue – and therefore no limit to the amount that they can sell.

In practice, though, there is a limit of sorts. Issuing more domestic currency inflates the money supply and if this is continued without offsetting policies then it threatens to cause an upsurge of inflation.

The obvious offsetting policy is to sell extra domestic assets to absorb the inflow of money. This is the policy known as sterilisation. In principle, this can continue without limit but it too has complications. A central bank has a limited range of assets that it can sell in order to absorb currency inflows – usually some sort of fixed interest instruments such as bonds or quasi-deposits. But money pouring in from abroad may seek employment in a whole panoply of assets, including not only bonds and bank deposits but also residential and commercial property and equities. In that case, selling large amounts of bonds and quasi-deposit type instruments may cause distortions in financial markets.

There is also the issue of the profitability of the central bank intervention. This can limit the extent of the gains from the policy – and certainly curtail central banks’ appetite for pursuing it. The effect on profitability depends, as usual, on two elements: capital gains and income.

If the central bank sells domestic currency to acquire foreign currency assets and is eventually obliged to let the currency rise then it will incur a capital loss.

The income element depends upon the relative cost of the domestic currency bonds that the central bank has to issue to raise the money to sell on the exchanges versus the interest income that can be earned on foreign currency assets. As it happens, in current circumstances, the UK government can borrow at very low interest rates.

The clearest example of a country finding it next to impossible to hold the exchange rate down is Switzerland in 2015. The Swiss National Bank tried to hold the Swiss franc down by dint of huge sales of Swiss francs on the exchanges. But in January 2015 it decided that it could hold on no longer and let the currency rise. This episode supposedly revealed that foreign exchange intervention is ultimately ineffective, even when the central bank is selling (and issuing) its own currency.

But the Swiss case is potentially highly misleading. In 2015, Switzerland ran a current account surplus of 11.4% of GDP, roughly 1.6 times the surplus (proportionately) of Germany, and 3.8 times that of China. The scale of this surplus indicated that without a radical change of circumstances or policy, the Swiss franc was substantially under-valued. Accordingly, it is no wonder that the Swiss National Bank could not hold the currency down.

There are also some clear examples of countries imposing substantial and painful distortions on their economies by operating policies that kept their exchange rates artificially low with the result that they ran substantial current account surpluses, whilst reducing consumption below what it could otherwise be. China and Japan fall into this category and so, arguably, does Germany. These examples do not set a happy precedent for the UK.

Needless to say, however, the UK is in a very different position. It has been running a huge current account deficit and there has been clear evidence that the currency has been over-valued. Accordingly, intervention to hold it down would be working with the grain of the economic fundamentals, not against them.

Quantitative easing could be deployed across the exchanges, that is to say, the Bank of England could purchase overseas assets. (This is good old fashioned intervention in the foreign exchange market.)

Perhaps this could even be done via the establishment of a UK sovereign wealth fund. Suppose that a country establishes a funded pension scheme by means of enforced deductions from pay. The funds received need to be invested somewhere. As with private schemes, it would be normal (and good) practice to invest a proportion of these funds abroad. The smaller the country in question, other things equal, the greater should be the proportion invested abroad. This may or may not result in downward pressure on the exchange rate, depending upon the response of individuals to the deductions from their pay (lower saving or lower spending) and the balance of domestic versus overseas in whatever individuals’ responses are.

In current circumstances, it would be impossible to raise extra money through taxation, and/or enforce deductions from pay (over and above those already in train under the government’s new pension policy). Might it be possible to establish such a fund by borrowing?  The UK government could establish an overseas investment fund, with money invested in overseas securities, funded by the issue of gilts. This would definitely exert downward pressure on the exchange rate. It would be the equivalent of a policy of QE but with foreign rather than domestic assets purchased.

A more discreet way of achieving the same thing would be to establish a fund to receive existing national insurance contributions, or at least a fraction of them, to be invested abroad. Of course the funds thus channelled into overseas investment would not be available for ordinary domestic expenditure and this would therefore create a domestic financial shortfall, which would have to be covered by borrowing. Accordingly, it amounts to the same idea as the one discussed above. But it may be presentationally and practically attractive, including in the way that it is presented to our G7 partners.

Under this suggestion, the official figures for net borrowing would be unaltered since extra gross borrowing would be offset by asset purchases. This would be the equivalent of a bout of ordinary sterilised foreign exchange intervention. To make this equivalent to unsterilised intervention the Bank of England would buy gilts equivalent to the extra ones issued. This would produce a situation akin to ordinary QE, except that there would now be extra gilts in issue, mirroring (and financing) the foreign securities held by the new Sovereign (Pension/National Insurance) fund.

4. Verbal direction and encouragement

Talk and guidance might seem attractive since this may be thought to have the smallest cost in regard to the distortion of policies in order to achieve an exchange rate objective. But unless it is backed up by one or more of the other policy instruments it is also unlikely to be very effective. Moreover, it is the policy lever that most obviously conflicts with our G7 obligations.

Equally, unless there is some verbal articulation of a new exchange rate policy, deployment of each of the other instruments may not be as effective as it might be since businesses might not perceive the change of policy and therefore might not fully believe that whatever exchange rate change happens is going to last. So ideally a policy to reduce the pound and or to keep it at its new lower level would involve a combination of all of the above instruments – and the perception that the authorities potentially have more of the same up their sleeve to deploy if necessary.

The power of words should not be under-estimated, particularly with regard to keeping a currency down, given that such words are backed up by the full panoply of macro and micro policy. Even if they stop short of declaring a formal range within which they intend the pound to trade (which would be against current G7 rules), the UK policy authorities could make it clear that they aim to keep the exchange rate competitive and that this objective will occupy a central place in their policy deliberations and policy settings.

5. Micro policies designed to make UK assets less attractive

(i) A different policy on foreign acquisitions of UK companies

Most countries are wary of allowing overseas interests to own and control more than a limited proportion of their major companies for strategic or other reasons. By both formal and informal methods, making unwanted take-overs difficult to accomplish, they have ways of discouraging overseas acquisition of businesses which they think are of national significance. In 2005, the French government drafted a law to protect ‘strategic industries’ from being purchased by companies owned elsewhere, thus protecting Danone, best known for its yoghurts, from being purchased by Pepsi-Cola or Nestle. In the same year, the US Senate passed a bill blocking the purchase of a number of US ports by Dubai Ports World on the grounds that this might compromise US security.

In UK, the old Monopolies and Mergers Commission was able to apply a public interest test to takeover proposals and the UK was therefore able to behave in a similar way to most other countries.

This changed in 1999, however, when the Monopolies and Mergers Commission was replaced by the Competition Commission which had no such remit. In the then prevailing UK climate of opinion – the market knows best and who owns or controls UK companies does not matter as long as competition is not impaired – the Competition Commission had no role to play in taking a view as to whether UK companies being acquired by overseas interests might have a wider national significance. As a result, the UK – encouraged by the City, which made large sums from the fees involved – became a happy hunting ground for any international company wanting to expand its foreign interests.

While direct investment in plant and machinery from foreign-owned business tends to be strongly advantageous to the UK economy, the overseas purchasing and ownership of existing companies has none of these advantages. It also has major downsides. Control goes abroad, and with it are inclined to go key research and investment decisions. Much of the tax base of such companies also goes abroad – certainly corporate tax. Also, often, the tax of non-dom executives. For entirely understandable reasons, international companies are bound to have a special regard for their home markets. With ownership goes the flow of profits and capital gains.

For all these reasons, a first step to take would be to reintroduce a public interest test for all takeovers, particularly those involving ownership and control from abroad, with these tests designed to take the wider interests of the UK economy as a whole into account, and not just narrow issues about competition.

The sums involved in allowing complete freedom for overseas takeovers are significant. In 2015, total overseas participation in the acquisition of UK companies amounted to just over £30bn. This compares to an overall current account deficit of £100bn. Between 2000 and 2007 the average annual inflow was £44bn. (Of course, we need to bear in mind that the UK is also highly active in purchasing companies overseas.)

(ii) Foreign acquisition of UK property

Net sales of UK property assets on a major scale have stemmed from a different source. The UK in general and London in particular provide a safe and secure environment for those in less stable parts of the world. Purchasing properties in the UK has increasingly become an attractive – and prestigious – way of investing footloose funds which might otherwise be at risk. Especially recently, the scale on which residential property is being bought by overseas residents rather than UK residents is staggering. A recent report indicated that about 75% of all new build houses and flats in London were being bought by overseas residents, while about half of all property transactions in London of more than £1m again involved overseas purchasers. (Admittedly, this total includes UK purchasers using foreign/offshore corporate structures.)

The result of this huge external demand on top of a faltering supply, combined with the UK’s rapidly rising population and very low interest rates for those in a position to borrow, has been a very rapid increase in house prices, freezing many potential first time buyers out of the market.

It is difficult to get hard and fast aggregate figures on the extent of overseas purchases of UK property. We estimate that since 2008, overseas companies and individuals may have bought about £150bn of UK commercial property and have sold about £90bn worth. So, in net terms, overseas asset purchases have amounted to about £60bn, some 17% of the value of all UK commercial property transactions over this period.

Data on residential sales are even sketchier. From the reports of leading estate agents it seems as though, between 2008 and mid-2014, about 10% of central London residential sales were to overseas buyers. On reasonable assumptions that would translate to a total inflow of just over £20bn.

As regards purchases of residential property, again there are fairly obvious routes to containing the scale on which this currently occurs. There could be much heavier taxation of foreign-owned houses and flats, especially those with very high value, where much of the problem resides. As most of the properties concerned are at the expensive end of the market, major tax increases focused on those owned by foreign registered companies or individuals domiciled abroad would only affect a limited number of housing units. This would be a further development of the policies already deployed by HM Treasury. But there have been pretty crudely designed to raise revenue and/or slow the top end of the market, rather than to target specifically the foreign purchase of UK property. (Interestingly, Australia prohibits foreigners from buying existing property but not from adding to the housing stock.)

Policies along these lines would not only reduce the upward pressure on the exchange rate, but they would also ease the strain on the UK property market generally, allowing more resources to be devoted to satisfying the housing needs of the indigenous population.

Conclusions on micro policy

We don’t need to lift up the drawbridge and to isolate ourselves from world capital markets, but equally we do not need to have most of our ports, airports, large manufacturing companies, utilities, energy companies, rail franchises, football clubs and much of our housing and real estate in foreign ownership. We need a reasonable balance, in the same way that applies in almost all other countries.

Nor would such a policy necessarily be to the disadvantage of the rest of the world, broadly considered. When Russian capital flows out of Russia and into UK assets, real and financial, whatever this might do to the prosperity of individual Russian wealth-holders, is it really in the interests of Russia?

Admittedly, in normal circumstances, it would not make sense to use micro measures, such as restrictions on overseas investments in UK assets, as a substitute for macro measures in order to achieve macro objectives. But it makes sense to temper the overseas appetite for our real assets for soundly-based other reasons. The fact that such action would tend to weaken the forces that put upward pressure on our exchange rate is an added bonus.

The policy regime

The policy instruments discussed above are of very different sorts. The tightness of fiscal policy and the attractions of UK assets to overseas wealth holders are not things that can be deployed at a moment’s notice to manage or influence the exchange rate. Rather, the settings of these variables can be made in regard to their impact on the exchange rate and then left there for extended periods. For short-term influence, the authorities would need to rely on extensive foreign exchange intervention, perhaps backed up by verbal guidance.

Equally, on their own, these two may not be very effective if they are deployed to try to achieve and sustain an exchange rate out of line with the economic fundamentals and with the stance of fiscal and monetary policy, and the relative attractiveness of UK assets to foreigners. What is needed is a policy regime which includes all these facets.

This essay is an edited extract from the book The Real Sterling Crisis: Why the UK needs a policy to keep the exchange rate down, which is available here.

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