THE British Labour party is in buoyant mood at its annual conference, expecting to be in power very soon. And it has already started to think about the consequences, including a possible run on the pound if it takes office. But not everyone thinks this is likely; Simon Wren-Lewis, an economist, challenged people to think of “a serious economic reason why stering would fall on the election of a Labour government?” Well, this blogger can think of several. 

1. Labour plans to increase the rate of tax on corporate profits from (what will be) 17% to 26%. That means the profits available to overseas investors will be reduced accordingly. They will demand a lower price to compensate for this lower return—this will either come in the form of a fall in the stockmarket or in the pound, or probably a bit of both.

2. Labour plans to nationalise various utilities (railways, water, the Royal Mail and some energy) and to cancel some private finance initiatives, by bringing them back into the public sector. It will compensate shareholders and PFI contractors with government bonds. It is safe to say that most investors will try to offload those bonds in the market. Overseas investors will demand a higher yield, or a lower pound, or a bit of both, to compensate for the risk of holding more UK bonds. 

3. Further to this last point, John McDonnell, the shadow chancellor, said on the BBC’s Today programme that Parliament would decide on the “market value” of any compensation, while Jeremy Corbyn told Channel 4’s Jon Snow last night that the great advantage of rewriting PFI contracts is that government bonds carry a lower interest rate than the contract agreement. Both suggest an element of appropriation in the deal. (On PFI, if you repay a £1,000 contract yielding 6% with £1,000 of bonds yielding 2%, you are making the other party worse off.)  This would fall foul of the European Court of Human Rights, which protects property owners against appropriation and requires them to be offered “reasonable compensation” via a method that is “manifestly reasonable” so there would be court action. Nevertheless, foreign investors might understandably conclude that a government which appropriates property in one area might do so in another; they would demand compensation for this risk in the form of a higher yield or lower pound.

4. On top of the extra bonds issued by Labour to pay for nationalisation, its tax and spending plans are likely to lead to a much greater deficit. The Institute for Fiscal Studies said its plans “would not raise as much money as they claim even in the short run, let alone the long run”. This would mean more bond issuance; again, overseas investors would demand a higher yield or lower pound to compensate.

5. Labour has a number of plans that may affect business investment; reducing labour market flexibility, raising the minimum wage, capping executive pay in companies that bid for public contracts, higher taxes on executives, creating extra public holidays etc. In aggregate, these will make the country less attractive for foreign direct investment at a time when Britain will already be struggling because of its intention to exit the EU, which makes the UK less appealing to companies that want to have a European base. As with points 1-4, this will be a problem because Britain has a current account deficit which means it needs to attract foreign capital every year; a lower pound (or higher yields) will be needed to entice the hot money that will replace the FDI. 

Those are just five reasons. One can think of more; Labour’s anti-American foreign policy and general hostility towards globalisation might also drive away investors, particularly American ones, who have seen the UK (and London, in particular) as a welcoming place. But all of these reasons revolve around the idea of a risk premium; a Labour government involves a greater risk and thus investors will be willing to buy UK assets at a lower price. Does this represent a sinister move by speculators to undermine democracy? Not really. Fund managers have the interests of their clients to consider and need to generate the highest returns; if a UK government threatens to cut those returns, it simply becomes less attractive. For the last 40 years or so, Britain has been a welcoming place for international capital; under Labour, which explicitly wants to return to a pre-Thatcherite system, it would be less so.

In a way, this is very similar to the reason why the pound fell after the referendum vote. The risk of holding UK assets went up, so the price fell.

Nothing is certain, of course, in currency markets. It could be that, by the time Labour gets into power, the current government has so mucked up the Brexit process that the pound has already taken a beating. Indeed, such a mess might be the main reason Labour wins office. Alternatively, the threat of a Labour government might lead to the pound falling before the election, giving it the scope to appreciate afterwards (the old saying is “sell on the rumour, buy on the news”). Or perhaps, Brexit will not have happened by the time of the next election and the pound might rally on the hope that Labour opts for a softer exit, perhaps staying in the single market, or the currency union.

Mr Wren-Lewis thinks that the pound will rise, not fall on Labour’s election. That is because Labour’s looser fiscal policy will be accompanied by a much tighter monetary policy from the Bank of England; these higher interest rates will attract foreign capital, and this will offset any capital flight. Tighter monetary policy would restrain economic growth, something a Labour government might not be happy about. Mr McDonnell has committed himself to maintaining Bank of England independence. In the past, however, he has suggested amending the Bank of England’s mandate to focus on more targets than inflation; a changed mandate might lead to reduced room for manoeuvre. This would be another reason why overseas investors would be more cautious about holding British assets (and thus lead to a lower pound).

Perhaps higher rates would be sufficient to offset the risk premium effect, although one suspects that rates will have to be quite a lot higher to compensate. So this argument effectively boils down to: “Don’t worry about a lower pound, your mortgage rate will be a lot higher.”  I’m not sure this is an election-winning slogan.

Source: economist
Why a Labour government might mean a fall in sterling