It is rather interesting to watch how Euro has strengthened so much & yet so fast against the sterling. Referring to the graph above, I wouldn’t be surprised if both move towards parity at £1 = €1.
Reasons for weakening pound against Euro:
(1) Economy is in bad shape. Recession in UK is far worse than many of those in Eurozone. The official data reported that output in the 4th quarter shrank by 1.5%, the sharpest contraction in 30 years. Economists fear that the worse is yet to come as we have not seen the last of de-multiplier effect feeding into the whole economic system. Over the time there will be more firms going under administration, increase in the number of unemployed, falling asset prices as banks are tidying their balance sheet & ballooning UK’s national debt. Many aggressive stances had been taken but its effect is yet to be seen owing to the lag effects. At the meantime, investors are fleeing pound denominated assets & convert to Euro, the next safest economy after US
(2) Cut in interest rates. MPC has been aggressively cutting interest rates since September 2007, where base rates stood at 5.75%. Now it is standing at only 1.5%. Rate cut generally encourage investors to switch to other currencies which have higher rate of return such as Euro. Although ECB has slashed interest rates several rounds, each cut was relatively small. As a result, Euro’s interest rate is always higher than in UK
(3) Euro as world reserve currency. Investors view the whole Eurozone as relatively a stable pact. Besides it has great economic diversity & the size of their GDP is even larger than US. For investors from Middle East, Euro is politically more attractive as it has less affluent in issues surrounding their area & around the world. As these investors ‘wanted to believe’ that Euro will one day replace the dollar as world trading currency, they slowly withdraw their pound assets & demand for euro currency causing it to appreciate
(4) Current account deficit. UK trade a lot with other European countries (like France, Germany & Italy) & its current account has almost been permanently in deficit. This is due to large deficits in the trade of goods, as UK people have high marginal propensity to import (high tendency to consume imported goods). Although there is an increase in the trade of services over the year, somehow it is still insufficient to offset the large deficit. To finance this, UK partly relies on the inflow of foreign capital or hot money, especially from Europe. But since the deficit is widening, it creates imbalances (outflow greater than inflow). As such pound devaluate
(5) Large national debt. UK’s debt has been increasing steeply in the recent as a result of heavy pump priming to revive the economy & not to mention bailing out those banks in trouble. Therefore it makes sense for the government to raise borrowing since their tax collection has also fallen. However, some investors began to view this as not manageable. They will not be keen to hold government bonds & securities. This leads to lower demand for pound causing it to fall
I hold my view that in 2009 pound & Euro will be on parity, considering other factors e.g. both in recession & interest rates about the same 1.5% (UK) vs. 2% (EU). However, the initial direction of pound also depends on how agressive it cut interest rates compared to ECB. When base rates are on par for both say 1%, then this view may hold