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Brexit Fears Stir Devaluation Risks, London’s Downfall

© Fotolia / RZPound sterling
Pound sterling - Sputnik International
As the UK is nearing its second major political referendum in less than two years, the Brexit debate has rendered financial market participant nervous, and Canary Wharf is seeing rife volatility, with the pound’s devaluation and capital outflows expected soon.

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Kristian Rouz – Heated debate over the UK’s possible exit from the EU in June has badly shaken the performance of the British shares and currency markets, with the pound sterling (GBP) having dropped below $1.40 on Wednesday, compared to its past year’s normal trading gauge of $1.42-$1.60.

The UK’s sterling might extend its losses against the greenback and fall to as low as $1.35 in a week from now, as concerns over financial stability of Canary Wharf in the fragile political environment are fending investors off the City of London.

At the same time, as the Brexit event is estimated to wipeout some 20% off the market value of British financial institutions, the anticipation of the referendum, due in June, is also reflecting negatively on Canary Wharf’s capitalization.

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As the broader British economy is heavily reliant on financial and energy sectors foremost, an extended period of financial turbulence means a rather grim economic outlook into the rest of 2016, regardless of the referendum’s outcome.

Devaluation of the sterling, triggered by Brexit speculation and the expectation of the referendum set for 23 June, might turn out to be sharper and deeper than initially projected. According to consensus estimate, the GBP might drop to $1.35 within a week, its lowest since 1985, hardly recovering losses until the referendum.

Should the UK vote ‘Out’, the pound might drop even further, to as low as $1.20, falling in line with January’s projections of Deutsche Bank, estimating the sterling’s FX rate at $1.27 by the end of 2016.

“A vote for Brexit would hit sterling hard,” Nick Kounis of the Amsterdam-based ABN Amro Bank NV said, because of “the negative implications for growth and hence interest rates, but also because of capital outflows and concerns about the financing of the current-account deficit.”

Indeed, rife political risks will hardly allow the Bank of England (BoE) to hike base interest rates this year from their ultra-low at 0.5%. Meanwhile, if the US Fed hikes rates to at least 0.5-0.75% till June, Britain will suffer heavy capital outflows (the BoE needs to keep their rates at least 0-0.25% above those of the US Fed to support the UK’s investment appeal).

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The British banking sector is likely to lose some 20% its capitalization, according to estimates by London-based Autonomous Research LLP, with commercial bonds rising in price and yield falling. Consequently, the growing dissatisfaction with the financial sector conditions in the UK would divert investors elsewhere, harming the broader economic expansion outlook.

Moreover, should Britain leave the EU, the BoE might even cut interest rates back to zero, resulting in an even greater investment outflow than that in case the rate remains at least unchanged. Currently, the UK economy is nearing the point where a hike in borrowing costs would be desirable, staving off bubbles in financial sector. Perhaps, the Brexit debate will now help cool the financial sector even without a raise in borrowing costs.

“If Brexit does happen we’ll see an immediate response from the Bank of England,” Enrique Diaz-Alvarez of the London-based Ebury Partners said. The regulator could “cut back to zero, removing all chances of a hike in the immediate future.”

However, the sterling had declined to comparable levels during the 2014 Scottish independence debate and subsequent referendum. The currency regained its value soon after Scotland voted to remain in the UK, and, as outlined by the BoE Governor Mark Carney, it is ‘increasingly clear’ that major political events are usually preceded by a devaluation of the sterling.

The current devaluation of the pound is, however, not a disaster, and the GBP FX rate had been unstable months prior to Brexit debate due to balance sheet deficit and a slump in oil prices.

“Brexit is certainly weighing on the pound,” Daniel Brehon of the London branch of Deutsche Bank. “But, structural concerns such as the current-account deficit were already a problem beforehand. Long-term depreciation may help boost inflation but pass-through has been underwhelming so far.”

Should the UK vote ‘In’ on 23 June, the pound is bound to regain its losses back to its normal trading range against the USD. In case of the ‘Out’ vote, the earlier projection of Deutsch Bank, with GBP hardly reaching $1.27 by the year-end, seems most viable.

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