Readers Question: I read a lot about the Dollar/Pound relationship but I want to know what the forecast is going to be for Euro/Pound. The Pound has lost again against the Euro and I don’t understand why as the UK economy is not doing too badly. Is the Pound going to be even less worth against the Euro say in three months? What is the factor that drives the value of the Pound down against the Euro?

Graph showing Value of Euro to Pound 1999-2008

Reasons Why the Pound has Devalued against the Euro

1. UK growth is slowing Down. Recently the IMF slashed its growth forecasts for the UK economy. The growth forecasts of the Treasury now look overly optimistic. There is even a chance of a recession towards the end of 2008 and early 2009. With a slowdown in economic growth and hence inflation, there will be room for the MPC to cut interest rates. Lower interest rates are very important for weakening a currency. Lower UK interest rates make it less attractive to buy Sterling and save money in the UK. Therefore, there are less hot money flows and a weaker value of Pound.
2. Housing Market. The UK Housing Market plays a crucial role in determining consumer confidence, spending and economic growth. Recently the rate of house price falls has accelerated and some people predict house price falls of upto 20%. If house prices fell by 20%, growth would slow down alot in the coming months. Again, this would lead to lower interest rates and a lower exchange rate. The markets are anticipating lower interest rates in the UK.
3. Credit Crisis. The UK is heavily exposed to the credit crisis because mortgage lending accounts for a high % of disposable income. Mortgage lending is more important in the UK than the Eurozone where mortgage payments account for a smaller % of disposable income. With less mortgages becoming available, demand for housing is falling. Also those with existing mortgages are seeing the cost of remortgaging increase. This is putting pressure on the Bank of England to reduce base rates to compensate for the increased bank rates. As they explained the recent interest rate cut:
   
   "The disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target."
   
4. The Euro is slowly becoming the World's Reserve Currency. With the Dollar in long term decline (and with good reason) government's and investment bankers are looking for an alternative to holding currency in the dollar; the main alternative is the Euro.
   However, it is worth noting the Pound has recently been weak against the Dollar as well, suggesting problems facing Sterling in particular.
5. UK Current account deficit. Relative to the EU, the UK is running a current account deficit, which puts downward pressure on sterling because of the outflow of foreign currency.

Predictions for Pound vs Euro in Next Few Months.

Some are suggesting the Pound could soon have parity with the Euro. £1 = 1Euro. I think this is unlikely, although not impossible. It depends on how serious the UK housing market slump will prove to be. If house prices really are overvalued by 25% then a fall in house prices will lead to lower interest rates and lower exchange rate. However, it may be the UK avoids a US style housing slump because we don't have the same problem of over supply.

Also the Strength of the Euro economy is perhaps over estimated. There are signs that EU exporters are suffering from the rising Euro; this may lead to lower European interest rates in the future, causing the Euro to weaken.

Conclusion

Present UK statistics present a fairly good picture. But, most analysts anticipate a deterioration in growth, mainly due to the state of the UK housing market. It is this fear of lower growth, recession and lower interest rates that are driving down sterling. If I was a foreign exchange dealer, I would not be buying sterling because the economic fundamentals are supporting a devaluation.

Related:

• Falling value of Sterling
• Forecast for Pound Sterling 2008

Reference
Picture from : Guardian - Pound falls to record low