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Library Note
Strength of the Pound Sterling: Economy and Investment
This House of Lords Library briefing has been prepared in advance of a debate that is scheduled to take
place in the House of Lords on 17 November 2016 on the following motion:
Baroness McIntosh of Pickering to move that this House takes note of the impact on the
economy and investment of fluctuations in the level of the pound sterling.
The International Monetary Fund describe the UK’s currency exchange as free-floating. Under such a
system the value of a given currency is the result of a set of complex relationships between economic
conditions and market forces. Consequently, the value of the pound has always fluctuated against other
currencies in response to these forces. Following the result of the UK’s referendum on its membership
of the EU, the value of the pound against both the US dollar and the euro fell markedly. The exchange
rate of the pound against the US dollar and the euro has continued to fluctuate. A weakened pound has
several implications for various aspects of the UK economy, notably imports and exports and the price
of goods and services.
Daily Spot Exchange Rate between Pound Sterling and the US Dollar and the Euro,
4 November 2015 to 4 November 2016
Euro
US Dollar
Exchange Rate to Pound Sterling
1.7
1.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
Date
Source: Bank of England, ‘Spot Exchange Rates; XUDLERS and XUDLUSS’, accessed 4 November 2016
This briefing presents information from the International Monetary Fund on different ways in which
currency exchange systems can be classified. It then provides recent data on the value of the pound and
commentary and analysis on the implications this has for aspects of the UK economy.
Charley Coleman
10 November 2016
LLN 2016/058
Table of Contents
1. Introduction .................................................................................................................................................. 1
2. Exchange Rates: An Introduction ............................................................................................................. 1
3. Pound Sterling Exchange Rates: Recent Developments ..................................................................... 2
4. Exchange Rate Changes: Impacts on the UK Economy ...................................................................... 6
4.1 Prices of Goods and Services ......................................................................................................... 7
4.2 Export Sales and International Trade ........................................................................................... 9
4.3 Foreign Direct Investment ............................................................................................................ 12
4.4 Public Sector Net Debt ................................................................................................................. 13
House of Lords Library Note I Strength of Pound Sterling
1
1. Introduction
Much recent commentary on the strength of the pound has been focused on the period
following the UK referendum on the EU, held on 23 June 2016. Following the vote to leave the
EU the value of the pound against the US dollar fell to a “30-year low”.1 This was followed by a
“31-year low” a few days later.2 The International Monetary Fund (IMF) describes the UK’s
currency exchange system as ‘free-floating’, meaning that the exchange rate of sterling is largely
market determined.3 The UK Government has stated that it:
[…] does not have a target for the sterling exchange rate and does not comment on
currency movements. Instead the exchange rate is allowed to adjust flexibly in response
to economic conditions, and movements in sterling are determined by market forces.4
It argues that the UK is:
[…] going through a period of adjustment as the economy responds to the vote to
leave the European Union. The fundamental strength of the UK economy means that it
is well-placed to deal with the challenges and take advantage of the opportunities that lie
ahead. The Government is working hard to lay the foundations for stable long term
growth which will benefit savers, pensioners and all other groups.5
This House of Lords Library briefing provides data on historical exchange rates and examines
some of the areas of the economy where fluctuations in the value of sterling are likely to have
the greatest effect.
2. Exchange Rates: An Introduction
Exchange rates can be set in different ways. The IMF describe three main types of foreign
exchange arrangements. Under each type exist several categories. Table 1 provides a summary
of these as described in the IMF’s Annual Report on Exchange Arrangements and Exchange
Restrictions (October 2015).
Table 1: International Monetary Fund Classification of Exchange Rate
Arrangements
Type
Categories
Description
Hard Pegs
 Exchange Rates With
In the case of exchange rates with no separate legal
tender, another country’s currency circulates as the
sole legal tender. Under a currency board
arrangement there exists a legislative obligation to
exchange domestic currency for a specified foreign
currency at a fixed exchange rate. This is combined
with restrictions on the issuance authority to ensure
the fulfilment of its legal obligation.
No Separate Legal
Tender
 Currency Board
Arrangement
1
Bloomberg, ‘Pound Plunges to 30-Year Low as UK Stocks Slide on Brexit’, 24 June 2016.
BBC News, ‘Pound Slides to Fresh 31-Year Low Against the Dollar’, 5 July 2016.
3
International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, October 2015.
4
House of Lords, ‘Written Question: Sterling’, 3 November 2016, HL2646.
5
ibid.
2
2
House of Lords Library Note I Strength of Pound Sterling
Soft Pegs
These include a variety of arrangements by which a
 Conventional Peg
 Pegged Exchange Rate given country’s currency is formally pegged at a
Within Horizontal
Bands
 Stabilised Arrangement
 Crawling Peg
 Crawl-like
Arrangement
Floating Regimes
 Floating
(market-determined  Free Floating
rates)
given rate to another currency, or ‘basket of
currencies’. Outside of a ‘conventional peg’ system
this can include maintaining the rate within a specific
percentage of the anchor currency or basket or it
may involve adjusting the currency in small amounts
at a fixed rate or in response to changes in selected
quantitative indicators (such as past inflation
differentials).
A floating exchange rate is largely market
determined. The IMF explains that foreign exchange
market intervention may occur, but it serves to
moderate the rate of change and prevent “undue
fluctuations”. It also states that policies which target
a specific level for the exchange rate are
“incompatible with floating”. In free floating systems
intervention occurs very rarely and the IMF only
classifies as free floating if interventions are limited
to no more than three instances in the preceding six
months. Each intervention can last no longer than
three business days.
The IMF considers that the United Kingdom has a free floating currency exchange system. The
UK Government has confirmed whilst it has an inflation target it has no policy aimed at fixing
exchange rates of the pound sterling and that the “value of sterling adjusts flexibly in response
to economic conditions and market forces”.6
Under such a system the value of a given currency is the result of a set of complex relationships
between various factors. This is one reason why currencies fluctuate, because they are
dependent on the level of an array of related values and activities. For example, the Bank of
England explains that a hypothetical rise in UK interest rates—relative to other countries—
would provide investors with a higher rate of return on assets in the UK, relative to equivalents
in foreign currencies.7 Using the Bank’s terminology, this in theory would make assets held in
sterling more “attractive”. In turn, the value of sterling should therefore rise which could
impact on other areas of economic activity such as exports and imports. However, the Bank
also states that “the impact of interest rates on the exchange rate is, unfortunately, seldom that
predictable”.8 The IMF explain that floating currencies “may exhibit more or less exchange rate
volatility, depending upon the size of the shocks affecting the economy”.9
3. Pound Sterling Exchange Rates: Recent Developments
This section of the briefing presents recent exchange rate data for the value of the pound.
Three measures are presented: the ‘effective exchange rate’ of pound sterling and its spot
exchange rate against the US dollar and against the euro. This briefing draws on data recorded
by the Bank of England.
6
House of Lords, ‘Written Question: Sterling’, 2 November 2016, HL2598.
Bank of England, ‘How Does Monetary Policy Work?’, accessed 3 November 2016.
8
ibid.
9
International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, October 2015,
p 72.
7
House of Lords Library Note I Strength of Pound Sterling
3
The sterling effective exchange rate index (ERI) is a measure of the strength of the pound
against a basket of other currencies. Countries are included in the narrow version of the index
if their share of either UK imports or exports on average over the latest three-year period
exceeds 1 percent. The ERI is calculated by weighting together bilateral exchange rates. The
Bank of England explains that the ERI is designed to measure changes in the price
competitiveness of traded goods and services, therefore the weights applied reflect trade flows
in manufactured goods and services.10 The Bank provides an illustrative example using the USA,
explaining that the weights for the US dollar in the sterling ERI are based on:
1.
Competition in the UK domestic market from imports from the USA
2.
Competition between UK exports and US products in the USA
3.
Competition between UK and US exports in third country markets11
Chart 1 displays the sterling ERI from 4 November 1999 to 4 November 2016.
Chart 1: Sterling Effective Exchange Rate Index, November 1999 to November
2016
Sterling ERI (Jan 2005=100)
120
100
80
60
40
20
0
Date
Source: Bank of England, ‘Effective Exchange Rate Index, Sterling (Jan 2005=100)—XUDLBK67’,
accessed 4 November 2016
Chart 2 displays the daily spot exchange rate between the pound sterling and the US dollar and
the euro over the same time period. Spot exchange rates are “indicative middle market (mean
of spot buying and selling) rates” as observed by the Bank of England’s foreign exchange desk in
the London interbank market at approximately 4pm.12 The Bank explains that these are not
“‘official’ rates and are no more authoritative than rates provided by any commercial bank
operating in the London market. Spot rates are applicable to deals executed for settlement two
working days later”.13 Please note that charts 1 and 2 use different measures of the strength of
the pound and are therefore not directly comparable.
10
Bank of England, ‘Annual Reweighting of the Sterling ERI’, accessed 7 November 2016.
ibid.
12
Bank of England, ‘Explanatory Notes: Spot Exchange Rates’, accessed 9 November 2016.
13
ibid.
11
4
House of Lords Library Note I Strength of Pound Sterling
Chart 2: Daily Spot Exchange Rate between Pound Sterling and the US Dollar and
the Euro, November 1999 to November 2016
Exchange Rate to Pound Sterling
2.5
Euro
US Dollar
2
1.5
1
0.5
0
Date
Source: Bank of England, ‘Spot Exchange Rates; XUDLERS and XUDLUSS’, accessed
4 November 2016
Much recent commentary on the strength of the pound has been focused on the period
following the UK referendum on the EU, held on 23 June 2016. For example, on 28 October
2016, the ONS argued that whilst the pound “has been falling for some time, the vote to leave
the European Union has had a big effect in recent months”.14 Chart 3 shows the daily spot
exchange rate between the pound sterling and the US dollar over the past 40 years. This shows
the recent fall in the value of the pound within a longer term context.
Chart 3: Daily Spot Exchange Rate between Pound Sterling and the US Dollar,
November 1976 to November 2016
Exchange Rate to Pound Sterling
3
2.5
2
1.5
1
0.5
0
Date
Source: Bank of England, ‘Spot Exchange Rates; XUDLUSS’, accessed 4 November 2016
14
Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for
People in the UK?’, 28 October 2016.
House of Lords Library Note I Strength of Pound Sterling
5
Following the vote to leave the EU the value of the pound against the US dollar fell to a “30
year low”.15 This was followed by a “31 year low” a few days later.16 On 9 July 2016, the
Economist argued that:
Though its value has fallen relative to the dollar, by other measures the pound is hardly
cheap. The “trade-weighted” sterling index, which is adjusted for the currencies of
Britain’s other trading partners, is still about 5 percent higher than it was at the peak of
the financial crisis. The euro has also been knocked in the post-referendum panic,
meaning that sterling’s losses against the currency of its biggest trading partner have
been trimmed.17
However, since 9 July 2016 sterling ERI has continued to fluctuate. On 8 July 2016 it stood at
78.24 and on 4 November 2016 it stood at 75.60, however it had been as high as 80.16. In
order to show changes in the level of the pound since the referendum in greater detail, charts 4
and 5 display data for sterling ERI and sterling exchange rate data since January 2016 only.
Please note that the scales for both charts do not start at 0 in order to provide greater
resolution.
Chart 4: Sterling Effective Exchange Rate Index, 4 November 2015 to 4 November
2016
Sterling ERI (Jan 2005=100)
100
95
90
85
80
75
70
65
60
Date
Source: Bank of England, ‘Effective Exchange Rate Index, Sterling (Jan 2005=100)—XUDLBK67’,
accessed 4 November 2016
15
Bloomberg, ‘Pound Plunges to 30-Year Low as UK Stocks Slide on Brexit’, 24 June 2016.
BBC News, ‘Pound Slides to Fresh 31-Year Low Against the Dollar’, 5 July 2016.
17
Economist, ‘How Low Can It Go?’, 9 July 2016.
16
6
House of Lords Library Note I Strength of Pound Sterling
Exchange Rate to Pound Sterling
Chart 5: Daily Spot Exchange Rate between Pound Sterling and the US Dollar and
the Euro, 4 November 2015 to 4 November 2016
Euro
1.7
US Dollar
1.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
Date
Source: Bank of England, ‘Spot Exchange Rates; XUDLERS and XUDLUSS’, accessed
4 November 2016
The subject of the relative strength of the pound sterling was discussed by the IMF as part of a
wider ‘Selected Issues Paper’ published in February 2016.18 In this the IMF described sterling as
being “moderately overvalued” by approximately 5 to 15 percent in the year 2015.19 However,
the IMF also stated that its analysis was based on the assumption that the UK would remain
within the EU. In a separate paper in June 2016, the IMF stated that:
An alternative scenario entailing higher trade barriers could reduce the equilibrium
exchange rate (as a more competitive exchange rate would be required to raise demand
for UK exports to offset the reduced demand from the EU due to higher barriers),
implying that additional depreciation from 2015 levels—beyond that implied by staff’s
assessment of overvalution in 2015—would be required to restore equilibrium in such a
scenario.20
Commenting on the report, the organisation Full Fact wrote that:
[…] it’s hard to say whether the value of the pound has dropped lower than what the
IMF would recommend. Since no-one knows what kind of trade relationships the UK
will have once it leaves the EU, opinions on the UK’s long-term potential for trade or
the best exchange rate for sterling are open to debate.21
4. Exchange Rate Changes: Impacts on the UK Economy
As described in section 2, the impact of sterling exchange rates on aspects of the UK economy
is complex. This section draws on authoritative sources and commentary to present
information on how this relationship may function. It focuses primarily on the impact of the
18
International Monetary Fund, United Kingdom: Selected Issues, February 2016.
ibid, pp 9–10.
20
International Monetary Fund, United Kingdom: 2016 Article IV Consultation—Press Release; and Staff Report, June
2016, p 8.
21
Full Fact, ‘Was the Pound Overvalued Before the EU Referendum?’, 17 October 2016.
19
House of Lords Library Note I Strength of Pound Sterling
7
exchange rate itself, rather than issues related to any hypothetical analysis of the UK’s future
relationship with the remaining 27 EU member states.
The announcement on 4 August 2016 of the Bank of England’s interest rate cut of 25 basis
points, to 0.25 percent (alongside a stimulus package), was aimed at meeting the monetary
policy of a 2 percent inflation target.22 In its announcement, the Bank of England argued that
following the result of the EU referendum:
[…] the exchange rate has fallen and the outlook for growth in the short to medium
term has weakened markedly. The fall in sterling is likely to push up on Consumer Price
Index (CPI) inflation in the near term, hastening its return to the 2 percent target and
probably causing it to rise above the target in the latter part of the Monetary Policy
Committee (MPC) forecast period, before the exchange rate effect dissipates
thereafter.23
The ONS has written that this cut in interest rates “all else being equal […] could cause
investors to move their money into other countries that may pay them a higher return”.24 It
also pointed to “expectations from some commentators” of lower growth and higher inflation
as possible reasons for the fall in the demand for sterling.25
4.1 Prices of Goods and Services
As the value of the pound decreases relative to other currencies, its buying power in foreign
currencies also decreases. This will have an immediate effect on holiday makers exchanging
pound sterling for currencies against which the pound has fallen.26 British people living abroad
and deriving their incomes in sterling, either through wages or pensions, may also see their
purchasing power decrease.27 Roger Blitz at the Financial Times also reported that the stock
market has risen as “many companies in the FTSE 100 and FTSE 250 get their earnings
abroad”.28
Recent press coverage has also reported on several high profile price rises, including Apple
increasing the prices of its range of computers29 and negotiations between Unilever and Tesco
on the price of products such as Marmite.30 The BBC has reported that “Unilever’s finance chief
said such price increases are a “normal” reaction to shifts in currency values”.31 Similarly, Apple
said that it:
[…] suggests product prices internationally on the basis of several factors, including
currency exchange rates, local import laws, business practices, taxes, and the cost of
doing business.32
22
Bank of England, ‘Bank of England Cuts Bank Rate to 0.25% and Introduces a Package of Measures Designed to
Provide Additional Monetary Stimulus’, 4 August 2016.
23
ibid.
24
Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for
People in the UK?’, 28 October 2016.
25
ibid.
26
Ben Chu, ‘7 Ways the Fall in the Value of the Pound Affects Us All’, Independent, 4 October 2016.
27
BBC News, ‘Brexit: Who is Affected by the Falling Pound?’, 29 June 2016.
28
Roger Blitz, ‘Who Are the Winners and Losers From the Pound’s Fall?’, Financial Times, 7 October 2016.
29
BBC News, ‘Apple Raises Computer Prices in UK’, 28 October 2016.
30
BBC News, ‘Tesco and Unilever End Price Dispute’, 13 October 2016.
31
ibid.
32
BBC News, ‘Apple Raises Computer Prices in UK’, 28 October 2016.
8
House of Lords Library Note I Strength of Pound Sterling
However, despite this relationship being theoretically a direct one, the ONS states that:
[…] it is difficult to predict how changes in the value of the pound will feed through to
the overall price level. There are many factors that could delay the effect (such as
supermarkets buying stock in advance) and some businesses may choose to absorb the
higher costs rather than pass them onto consumers.33
The Consumer Price Index (CPI) is a measure of inflation. The most recent data published by
the ONS states that CPI rose by 1 percent in the year to September.34 The ONS explains that
this was influenced by increases in the price of certain goods, but offset by falls in others:
The main upward contributors to change in the rate were rising prices for clothing,
overnight hotel stays and motor fuels, and prices for gas, which were unchanged, having
fallen a year ago. These upward pressures were partially offset by a fall in air fares and
food prices.35
The ONS has published a bulletin alongside this that provides additional analysis of how changes
in the value of sterling could have influenced CPI. It also examines the effect on the Producer
Price Index (PPI)—a measure of the change in the prices of goods bought and sold by UK
manufacturers.36 The ONS explains that:
Input producer prices increased by 7.2 percent in the year to September 2016,
compared with a 7.8 percent increase in the year to August 2016, the third consecutive
month of positive input price inflation. The recent return to positive producer price
inflation can be partly attributed to the changes in the sterling exchange rate, with the
effective sterling exchange rate depreciating by 14.4 percent in the year to September
2016. All else equal, a depreciation of sterling increases the prices of UK imports, with a
corresponding impact on the prices paid by producers for imports. If these producers
raise their prices in turn, then movements in the exchange rate can influence output
producer prices.37
However, the ONS noted that inflation “has been on an upward trend since late 2015”.38 The
ONS has analysed the contributions to CPI of goods and services according to their import
intensity between January 2008 and September 2016. The term ‘import intensity’ refers to the
percentage of final household consumption which is directly due to imports. It found that:
[…] the least import-intensive non-energy products have made a fairly steady
contribution to the CPI rate of inflation between 2008 and 2016. More import-intensive
products, by contrast, account for much of the rise in inflation following the
depreciation of sterling in 2008 and 2009 and for much of the moderation of inflation
over the last two years—a period during which sterling appreciated against its major
trading partners.
33
Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for
People in the UK?’, 28 October 2016.
34
Office for National Statistics, ‘UK Consumer Price Inflation: Sept 2016’, 18 October 2016.
35
ibid.
36
Office for National Statistics, ‘Additional Analysis of the Producer Price Index (PPI) and Consumer Price Index
(CPI): Sept 2016’, 18 October 2016.
37
ibid.
38
Office for National Statistics, ‘UK Consumer Price Inflation: Sept 2016’, 18 October 2016.
House of Lords Library Note I Strength of Pound Sterling
9
In September 2016, the largest contribution to consumer price inflation continued to
come from goods in the lowest import intensity category (0 to 10 percent). This group
of products and services still dominates the slight upward contribution seen for the
most import intensive goods and services (40 percent plus), and the contributions for
each category increased by comparable amounts in September.
Energy has seen a fall in its negative contribution to the CPI in September 2016. This can
mainly be attributed to price falls between August and September last year, although it is
possible that it could be influenced by the stabilising of commodity prices being offset by
the depreciation of sterling.39
The Head of Inflation at the ONS, Mike Prestwood, stated that September’s inflation figures
suggest “there is no explicit evidence the lower pound is pushing up the prices of everyday
consumer goods”.40
4.2 Export Sales and International Trade
As a fall in the value of the pound relative to other currencies may be expected to increase the
price of imports, it may also be expected to make UK exports cheaper and more price
competitive. As a consequence, more money may flow into the UK economy through increased
exports. As with price rises for imported goods, there are many practical considerations as to
why this relationship may not purely be a direct one.
The ONS argues that factors influencing this relationship include:

How well UK companies are set up to exploit export markets—for example, it
can take time for a business to adapt its processes to sell overseas and find
profitable opportunities where potential customers will demand its goods.

The economic conditions in other countries—if other countries are in an
economic downturn they will not have the money to spend on our goods.

How sensitive the demand for our exports is to price—for example we export
Rolls Royce cars but the demand for these is not very sensitive to price changes
as they are a luxury item. This means the number sold may not significantly
change as the price changes.

The trade arrangements that exist to access markets across the world.41
Writing on the Centre for Economic Policy Research’s policy blog in October 2015,
researchers from the IMF wrote that some have argued that exchange rates have a reduced
impact on trade compared to the past:
Exchange rate movements have been unusually large and have sparked some
controversy as to their likely effect on exports and imports. Some suggest that exchange
rates matter far less than they used to, and may have disconnected from trade entirely.
39
Office for National Statistics, ‘Additional Analysis of the Producer Price Index (PPI) and Consumer Price Index
(CPI): Sept 2016’, 18 October 2016.
40
Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for
People in the UK?’, 28 October 2016.
41
ibid.
10
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Claims like these are not at all new—they have been around at least since the
economist Fritz Machlup coined the phrase ‘elasticity pessimism’ back in 1950.42
The authors state that this argument is often based on the assertion that the production of
goods has become “fragmented across countries in global value chains”.43 They point to the
example of smartphones assembled in China from parts manufactured in multiple countries, and
observe that:
A rising share of exports consists of components imported from abroad (foreign value
content), and a currency depreciation should thus provide a more limited boost to
exports. The puzzling weakness of Japanese exports since 2012 despite the yen’s
depreciation of more than 30 percent in real effective terms has further fuelled the
disconnect debate.44
Based on their own analysis, the authors argue against this point.45 Looking at data on
50 advanced and emerging market and developing economies over the last 30 years they assert
that there is a “strong link between exchange rates and trade”, stating that “overall, we
estimate that 10 percent real effective exchange rate depreciation implies, on average, a
1.5 percent of GDP increase in real net exports”.46 However, they also state that there is
substantial cross-country variation around this average.47 They also that:
[…] these effects fully materialize over a number of years, [but] much of the adjustment
occurs in the first year. The boost to exports associated with currency depreciation is
found to be largest in countries with initial economic slack and with domestic financial
systems that are operating normally. Some evidence suggests that the rise of global value
chains has weakened the relationship between exchange rates and trade in intermediate
products used as inputs into other economies’ exports. However, the bulk of global
trade still consists of conventional trade, and there is little evidence of a general trend
toward disconnect between exchange rates and total exports and imports.48
Between Q3 2007 and Q1 2009 the sterling effective exchange rate depreciated by 25 percent
following the “economic downturn”.49 In August 2013, the ONS examined what effect this fall
had on the UK’s balance of trade in subsequent years. Writing at the time, the ONS stated that
“despite a brief increase between Q2 2007 and Q4 2008, the trade balance has remained
around its pre-depreciation level and shows little clear evidence of the depreciation”.50 The
ONS argued that whilst the performance of exports relative to imports did improve following
the depreciation, given the “magnitude” of the fall in sterling “a stronger response might have
been expected from exports in particular”.51
42
Daniel Leigh et al, ‘Exchange Rates Still Matter for Trade’, Centre for Economic Policy Research Policy Blog,
30 October 2015.
43
ibid.
44
ibid.
45
International Monetary Fund, World Economic Outlook—Chapter 3: Exchange Rates and Trade Flows: Disconnected?,
October 2015, pp 105–42.
46
ibid.
47
ibid, p 105.
48
ibid.
49
Office for National Statistics, Explanation Beyond Exchange Rates: Trends in UK Trade Since 2007, 22 August 2013.
50
ibid, p 4.
51
ibid, p 5.
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The ONS concluded that the following factors may explain this response:

The UK has become more deeply integrated into the global economy, and the
increasingly global nature of supply chains.52

An increasingly large percentage of the UK’s exports came from services;
between 1998 and 2007 the proportion increased from 30.2 percent to
approximately 42.2 percent of all exports. The ONS argued that this made UK
exports particularly vulnerable to the downturn in the world economy in 2007.53

The fact that firms may or may not pass on the full cost, or benefit, of an
exchange rate change to customers. The ONS stated that:
[…] the depreciation appears to have had the predicted effect on sterling
import prices, which increased by 21 percent between Q4 2007 and
Q4 2012. The depreciation also had the predicted impact on the effective
price of UK exports, which fell sharply during Q4 2008 and Q1 2009,
supporting the recovery in trade during 2009 and 2010. However,
effective export prices have since risen above their pre-depreciation level,
which may offer a partial explanation for the recent weakness of trade.54

The ONS also highlighted the role of commodities, particularly oil, describing
modern economies as having a relatively “price inelastic demand for oil”.55 The
ONS wrote that the “rise in the dollar price of oil, the depreciation of sterling
and the relatively inelastic demand for oil have had a substantial impact on the
UK’s trade position”.56

Annual CPI inflation was consistently higher in the UK than other G7 countries.
The ONS explained that:
If prices in one economy rise more rapidly than those in other economies
with no change in the exchange rate, the balance of trade is likely to
change. Higher domestic prices make domestic goods relatively more
expensive in overseas markets. This reduces demand for domestic
exports. Higher domestic prices also make imported goods relatively
more attractive for domestic firms and consumers. As a result,
consistent, relatively high rates of inflation tend to reduce the trade
balance through lower exports and higher imports.57

52
The ONS argued that many of the UK’s trading partners had suffered
“contractions in output, increases in unemployment and correspondingly limited
demand growth”.58 The ONS suggested that this may have limited the impact of
the change in the exchange rate due to decreasing demand for UK products
overseas.
Office for National Statistics, Explanation Beyond Exchange Rates: Trends in UK Trade Since 2007, 22 August 2013,
p 8.
53
ibid, p 10.
54
ibid, p 16.
55
ibid, p 16.
56
ibid, p 18.
57
ibid, p 19.
58
ibid, p 21.
12
House of Lords Library Note I Strength of Pound Sterling
In October 2016, the ONS stated that it has “limited data on how exports have performed
following the [recent] fall in the pound”.59
4.3 Foreign Direct Investment
The United Nations Conference on Trade and Development (UNCTAD) defines foreign direct
investment (FDI) as an investment which is made to:
[…] acquire lasting interest in enterprises operating outside of the economy of the
investor. Further, in cases of FDI, the investor’s purpose is to gain an effective voice in
the management of the enterprise. The foreign entity or group of associated entities
that makes the investment is termed the “direct investor”. The unincorporated or
incorporated enterprise—a branch or subsidiary, respectively, in which direct
investment is made—is referred to as a “direct investment enterprise”.60
UNCTAD states that some degree of equity ownership is normally considered as necessary to
be considered to have an effective voice in the management of an enterprise. Generally, this is
considered to be 10 percent of equity ownership.61
The ONS has produced a short briefing on the impact of the recent changes in the value of
sterling on FDI. UK investments in overseas companies are referred to as FDI assets. Overseas
investors’ investments in the UK are known as FDI liabilities. It explains that “as with many
cross-border economic statistics”, UK FDI values fluctuate in response to changes in currency
exchange rates.62 FDI assets are more likely to be denominated in foreign currency as
compared with overseas investments in the UK, according to the ONS. Therefore, it argues
that UK FDI assets should experience larger revaluations in response to fluctuations in sterling.
The ONS stated that:
As asset and liability values are measured at the period end, the depreciation in sterling
in the final few days of Quarter 2 2016 will have impacted on the UK’s international
investment position for Quarter 2 2016. In contrast, the impact on earnings is likely to
be less immediate, as only earnings in the final seven days of the quarter are affected;
although, should the sterling exchange rate remain at current levels, earnings in future
quarters will be affected, all else being equal.63
Foreign Investment in UK Assets
Following the depreciation in the pound there have been press reports that purchase of UK
assets may become more attractive as foreign currencies strengthen against sterling.
59
Office for National Statistics, ‘Why Has the Value of the Pound Been Falling and What Could this Mean for
People in the UK?’, 28 October 2016.
60
United Nations Conference on Trade and Development, ‘Foreign Direct Investment (FDI)’, accessed
8 November 2016.
61
ibid.
62
Office for National Statistics, ‘The Impact of Recent Currency Fluctuations on Foreign Direct Investment (FDI)
Statistics: Quarter 2 (Apr to June) 2016’, 30 September 2016.
63
ibid.
House of Lords Library Note I Strength of Pound Sterling
13
On 6 July 2016, an article in the Telegraph said that:
Investment managers have reported an increase in enquiries from overseas money
wanting to buy sterling-linked assets, particularly commercial property, with the current
exchange rate meaning they will get a better deal.64
However, it went on to say that according to those “working in the sector” investors are
“concerned” about the “wider volatility in the UK since the result of the European Union
referendum and are likely to sit on capital until some of the political and economic uncertainty
is resolved”.65 Writing about the purchase of the British technology firm ARM Holdings by the
Japanese company Softbank, the BBC’s Business Editor, Simon Jack, wrote that the desirability
of ARM had been
[…] boosted by the fall in the value of the pound since Brexit—making UK targets
cheaper and many industry watchers are predicting a new wave of foreign takeovers.66
The BBC also quoted Dan Ridsdale, an analyst at Edison Investment Research, as saying that:
An increase in inbound merger and acquisition activity was one of the obvious
consequences of Brexit and weakened sterling, but few expected it to manifest itself so
quickly or at so large a scale.67
However, the Wall Street Journal reported that:
Despite the recent drop in the value of the British pound after [the UK’s] decision to
exit the EU, Mr Son [Softbank’s Chief Executive] said that didn’t affect his decision. The
deal doesn’t actually bring a so-called Brexit discount, because ARM’s shares have
traded higher over the past month, more than offsetting the drop in the pound since the
Brexit vote.68
4.4 Public Sector Net Debt
Fluctuations in the value of sterling may also be expected to have an effect on public sector
finance. On 14 July 2016, the ONS published a short briefing stating the recent large
movements in the value of sterling “highlighted a need for clarity on the impact of these
exchange rate movements on the Public Sector Net Debt (PSND)”.69 The ONS explained that:
Public Sector Net Debt (PSND) is net of liquid assets and more than half of these liquid
assets are held as foreign currency assets in the Official Reserves. Recent falls in the
price of sterling will have led to an increase in the sterling value of these foreign
currency assets and so, all other things being equal, a fall in PSND. However, around
two thirds of the foreign currency assets in the Official Reserves are ‘hedged’ against
exchange rate movements largely through the use of currency swaps. The swaps
effectively fix the sterling value of these assets. Where this hedging is in place the value
64
Rhiannon Bury, ‘Opportunistic Foreign Investors May Swoop on UK Assets as Pound Slumps’, Telegraph, 6 July
2016
65
ibid.
66
BBC News, ‘ARM Chip Designer to be Bought by Japan's Softbank’, 18 July 2016.
67
ibid.
68
Stu Woo, Rick Carew and Eva Dou, ‘SoftBank to Buy ARM Holdings for $32 Billion’, Wall Street Journal, 18 July
2016.
69
Office for National Statistics, ‘Impact of Foreign Exchange Rate Movements on Public Sector Net Debt’, 14 July
2016.
14
House of Lords Library Note I Strength of Pound Sterling
of the assets as recorded in debt will not vary with the latest exchange rates but will
reflect the ‘fixed’ sterling value. This means that the reduction in PSND will be less than
might be expected based on the movement in exchange rates.70
The ONS announced a methodological change for the June 2016 Public Sector Finances
Bulletin, the effect of which:
[…] introduces a change to the PSND methodology in relation to the valuation of
foreign currency denominated liquid assets which are “hedged” against exchange rate
and price movements. In recent periods the value of these assets changed with
movements in foreign currency exchange rates but the new methodology guidance
states that the assets are to be valued at the sterling value ‘fixed’ through the hedging
instrument.71
This followed a recommendation of the Public Sector Finances Technical Advisory Group
(PSFTAG).72
70
Office for National Statistics, ‘Impact of Foreign Exchange Rate Movements on Public Sector Net Debt’, 14 July
2016.
71
Office for National Statistics, ‘Public Sector Finances: June 2016’, 21 July 2016.
72
Office for National Statistics, ‘Impact of Foreign Exchange Rate Movements on Public Sector Net Debt’, 14 July
2016.
House of Lords Library Notes are compiled for the benefit of Members of the House of Lords and their personal staff,
to provide impartial, politically balanced briefing on subjects likely to be of interest to Members of the Lords. Authors
are available to discuss the contents of the Notes with the Members and their staff but cannot advise members of the
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Any comments on Library Notes should be sent to the Head of Research Services, House of Lords Library,
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