A crashing pound can have far-reaching effects on the UK economy. Here’s a look at some of the key impacts of a weakening pound.
Higher inflation
A falling pound makes imports more expensive, pushing up inflation. Many raw materials, components and finished goods are priced in dollars or euros. As the pound weakens, it costs more to buy these items. Higher import prices feed through into higher consumer prices.
The UK imports around half of its food, so grocery bills rise when the pound falls. Energy bills also increase as oil and wholesale gas is priced in dollars. Higher inflation hits household budgets and could lead the Bank of England to raise interest rates.
Weaker economic growth
Higher inflation causes consumers to cut back on discretionary spending, dampening economic growth. Businesses may also delay investment and hiring decisions when inflation is high and the outlook uncertain.
A crashing pound can therefore tip the economy into recession. The 2008 financial crisis was exacerbated by a plunging pound, which contributed to the UK’s deepest recession in decades.
Lower living standards
High inflation erodes consumer purchasing power. When incomes fail to keep up with rising prices, people’s living standards suffer. The UK is currently grappling with a cost-of-living crisis due to double-digit food and energy inflation.
With inflation expected to rise further, a crashing pound would put even more pressure on households. The poorest in society are often the hardest hit, as they spend a higher proportion of income on essentials.
Cheaper exports
A positive effect of a weaker pound is to make UK exports more competitive. With the pound low against other currencies, UK goods and services are cheaper for overseas buyers.
This boosts demand for British exports like machinery, pharmaceuticals, tech and creative services. However, the benefits are limited as the UK is less reliant on manufacturing and exports than in the past.
Foreign investment could fall
The UK has attracted substantial foreign direct investment in recent decades, thanks to its open economy and business-friendly policies. However, currency instability can deter multinational companies from investing and expanding operations in the UK.
They may see the pound as risky and switch future investments to more stable currencies like the dollar or euro. So a crashing pound could harm the UK’s long-term growth prospects.
Higher debt costs
A weaker currency makes repaying foreign currency-denominated debt more expensive. With the pound down, the relative value of repayments on bonds, loans and other liabilities rises.
This is a concern for UK banks and companies that have borrowed in dollars or euros. It also raises the cost for the government to service its foreign debt and could force tax hikes to cover higher interest payments.
Mortgage and borrowing rates could rise
To counter rising inflation, the Bank of England may be forced to raise interest rates if the pound crashes severely. Higher interest rates feed through into higher mortgage repayments and borrowing costs for consumers and businesses.
Many UK households are already struggling with debt, so higher interest costs add further pressure. Rising corporate borrowing costs also depress business investment and jobs.
Pressure on the financial system
A plunging pound can destabilize the UK financial system. Banks and investment funds with significant dollar or euro assets and liabilities on their balance sheets suffer large losses when the pound falls.
This can spark wider contagion and credit tightening, as seen in 2008 when sterling’s fall contributed to the seizing up of interbank lending. Financial stability is critical for the economy’s health, so a crashing pound could have pronounced aftershocks.
Loss of international purchasing power
A weaker pound means Britons’ money does not go as far when they travel, study or purchase foreign goods and services. Tourist destinations become more expensive, reducing leisure travel. People may opt for “staycations” instead.
UK students find overseas university fees more costly. Retirees’ pensions drop in value if denominated in foreign currencies. Overall, the UK’s international purchasing power declines as the pound depreciates.
Wealth destruction
Currency depreciation destroys wealth, as the pound’s internal and external value is eroded. Asset prices often correct lower to reflect the weaker fundamentals. Share prices fall, reducing wealth for investors and pension savers.
Property prices may also decline if higher mortgage rates and construction costs make houses less affordable. Falling asset prices have negative wealth effects, reducing consumer confidence and spending throughout the economy.
Possibility of a sterling crisis
In a worst-case scenario, a crashing pound could produce a sterling crisis. If investors lose all confidence in the pound, its value can enter freefall, as happened on Black Wednesday in 1992 when the UK crashed out of the European Exchange Rate Mechanism (ERM).
A plunging currency then risks hyperinflation, emergency interest rate hikes, and a full-blown financial crisis. To restore stability, international support and intervention may be needed, as the UK discovered in the 1970s when the IMF had to bail out a collapsing pound.
Conclusion
A crashing or weakening pound is generally bad news for the UK economy and consumers. Some export sectors may benefit, but the overall effects are negative. Higher inflation, weaker growth, falling living standards and wealth destruction are probable results.
In a worst case, it could necessitate drastic action by policymakers to defend sterling and avoid financial meltdown. Maintaining confidence in the pound’s value is essential for economic and political stability.