Friday, August 7, 2015

The Great British Pound Appreciation of 1996-1997

Above is the historical trade weighted exchange rate for British Pound. Since the latest 80’s there are 3 episodes of big moves. First a gap down around 1992, then a big spike up from second half of 1996 to early 1998, and finally the collapse from 2H07 to end of 2008. The last one is straightforward– the Great Financial Crisis really started in 2007 after the subprime bubble popped. The first one I know also. That was Soros and Druckenmiller breaking the Bank of England.

But what about that big run up in 1996-1997? What happened there?

The Bank of England does a great job of archiving their old reports, and one can quickly figure this out by searching through their Inflation Reports from 1996-1997. What happened was a rare combination of 1) monetary divergence, 2) fiscal divergence, and 3) political uncertainty in the rest of Europe.

The monetary policy part is fairly similar to what’s happening today. Back in 1996 the market expected other European countries to lower their rates while Bank of England was expected to tighten money.

But that was only part of the story. The real driver there was countries gearing up to join the Euro system. Keep in mind this is 1996 and the Euro did not exist yet. Other European countries were preparing to join the EMU and they had to meet the “Maastricht convergence criteria” – which would require them to reduce budget deficits. Here’s how the old BOE report explained it:

“A reduction in planned fiscal deficits abroad—such as that taking place on the Continent to meet the Maastricht convergence criteria—would tend to reduce interest rates there, both because lower deficits raise national saving and because fiscal consolidation may reduce aggregate demand in the short run. The exchange rates of the countries undertaking fiscal consolidation would depreciate as financial capital sought higher returns elsewhere”
And this: 
the portfolio shift away from currencies of countries most likely to participate in EMU may also have reflected higher risk premia because of the uncertainties involved”
To prove the importance of the EMU and Maastricht convergence, BOE’s November 1997 report even had an interesting study showing that the Italian Lira and Deutsche Mark were getting increasingly correlated, while Sterling/Mark significantly less so. 

So there, a combination of monetary divergence and expected fiscal divergence (due to the advent of Euro) caused the GBP to revaluate upward in 1996-1997.

Here’s what I couldn’t help wonder though: how much of U.K. not joining the Euro could be attributed to its humiliating experience in 1992 trying to tie a currency? Is it possible that Soros, Druckenmiller, and the currency speculation world “taught” U.K. the importance of having an independent monetary policy? Without Black Wednesday, could U.K. have ditched the GBP for the EUR?

If so, Soros and gang might have "broke" the Bank of England, but they saved the GBP.

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