Why is the pound sterling falling and what does this mean for the rest of the world?

The pound hit a record low against the dollar after the UK government announced sweeping tax cuts in a mini-budget last Friday. So why is sterling falling so steeply and what does this mean for the rest of the world?

What is a currency crisis?

When the currency markets turn against a country, the value of that country’s currency begins to decline. For example, the Turkish currency is about 40% weaker against the US dollar than last year after traders were spooked by a surge in annual inflation to over 70%.

The British pound has fallen in recent weeks as markets have become disillusioned with the new government led by newly appointed Prime Minister Liz Truss. It signaled an expansive economic policy based on far-reaching tax cuts.

Its top finance minister, or chancellor, Kwasi Kwarteng has been accused of ignoring a 9.9% inflation rate that economists said would only get worse, opting instead to include much more in Friday morning’s mini-budget pumping money into the economy. Forex traders gave their verdict over the weekend and Monday, sending the pound from near $1.20 to a record low of $1.03 before partially recovering to $1.06.

A sudden and sharp fall in sterling creates uncertainty and upsets the plans of UK companies importing and exporting goods. They expect a certain amount for imports and a certain price for goods and services they sell abroad. All of that changes when the currency falls. When the pound is worth less, the cost of importing goods from overseas increases.

What does this mean for the UK?

A weaker pound means price increases for British consumers buying goods from abroad, and it means their money doesn’t go as far when traveling to the US or countries that use the US dollar.

Oil is one of Britain’s most important imports and is traded in dollars on international commodity markets. A weak pound makes it more expensive to fill up a car with diesel or petrol. Gasoline is also billed in dollars.

The UK also imports more than 50% of its food, so the cost of everything from artichokes to bananas is rising.

Why is it happening?

Truss wants to make tax cuts in the new year that will be paid for by higher national debt. She believes the extra money will be used to fund investment and improve the UK’s productivity. But skeptics say putting more money in the hands of individuals will increase demand and push up inflation. A pledge by Kwarteng over the weekend to further cut taxes in the new year has only increased fears of a renewed rise in inflation.

Investors are also concerned that the additional borrowing will not be recouped by higher growth and improved tax revenues, leaving the UK with worsening debt over the long term.

Part of the pound’s weakness is also the strength of the dollar, which has risen as the US Federal Reserve aggressively hikes interest rates. However, the pound sell-off has accelerated significantly following the announcement of the tax cuts.

How will this affect other countries?

It makes goods and services and assets cheap in the UK. Foreign investors could go shopping to soak up assets that would otherwise have cost much more to buy. Tourists visiting the UK also have more money to spend and can take advantage of the improved exchange rate.

Investors who previously bought UK assets will see the fall in value. Some investors will insist that their investment returns be paid in dollars. Others will sell the asset, especially if they think the currency is likely to continue falling.

What is the British government doing about it?

The next step is likely to be taken by the Bank of England, which could raise interest rates more than previously expected. It’s possible the bank will announce an emergency hike before its next scheduled policy decision on November 3.

A statement on Monday said officials would “make a full assessment of the impact of the government’s announcements on demand and inflation, and the fall in sterling, and act accordingly at their next scheduled meeting”.

Higher interest rates attract savings to the UK and tend to increase the value of the pound. However, they also increase the cost of borrowing for households and businesses.

In the past, governments have tried to reassure markets by announcing how they intend to cut public spending to balance the books.

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