PureFX

How Does The UK Recession Affect The Exchange Rate?

Wed 18th July 2012

By Peter Lavelle

The recession in the UK affects the exchange rate by weakening the pound against other currencies. For example, imagine you have UK pounds and want to buy Australian dollars. If the UK enters recession, then the pound is likely to lose value against the Australian dollar, making it more expensive to buy them.

If you’re intent on buying a house in Australia, or importing Australian goods to the UK, you will therefore need more pounds to reach the required Australian dollar total.

The reason this happens is that, if the UK enters recession, it sends a negative signal about Britain’s economic prospects. Interest rates are likely to be cut, to make borrowing cheaper and encourage investment. Unemployment is likely to rise, as businesses cut back to keep themselves afloat. Consumers too will spend less on the high street. In general, there is less prosperity about the place.

That therefore makes it less likely international investors will want to put money in the UK, because the potential for big financial returns is limited. That in turn weakens the pound, as demand for UK sterling (needed to invest in UK projects) goes down.

Of course, just because the UK is in recession, doesn’t guarantee that the pound will fall. For instance, in the last 3 months UK sterling has climbed to its highest point against the euro since 2008, in spite of the fact that the UK is in recession and the Eurozone is not. Why is this? It’s because, though the UK is in recession, its political framework is much more stable than that of Europe.

Put another way, there is very little chance the UK will collapse in the immediate future, while that is a distinct possibility for Europe. Hence, this is a case in which recession is not the dominating factor in the foreign exchange rate. The pound can climb, even though (economically speaking) the UK is in an officially worse state.

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