Sterling's recovery expected to persist

The value of sterling recovered by 7.8 per cent against the euro and 15 per cent versus the dollar since March with many economists widely expecting this trend to persist in the coming months and during the course of 2010.

Despite its recent recovery from a 23-year low against the greenback, and near parity with the euro at the beginning of the year, the current level of the British pound is still substantially below that which prevailed in the period before the bankruptcy of Lehman Brothers.

On August 11, 2008, just a month before the start of the financial market turbulence, sterling stood at £0.782 against the euro and £1.9104 against the dollar. During the final three months of 2008, sterling weakened significantly to end the year showing a 30 per cent decline against the value of the euro.

In recent weeks, some commentators speculated that the worst of the economic collapse was over as some leading indicators, such as the Purchasing Managers' Index for the services sectors, revealed that the UK manufacturing sector expanded for the first time since April 2008.

Some economists suggest that the wider economy would stop contracting in the second half of the year and, in their view, "there is consequently a small possibility that UK's GDP growth in the second quarter will turn out closer to zero."

The recent thinking that the recession in the UK might not turn out to be as deep and long as initially feared also impacted other parts of the financial markets. Investor confidence improved and risk appetite returned as seen by the narrowing of credit risk spreads and the strong recovery also in equity markets since hitting multi-year lows in March.

Some critics view the timing of sterling's appreciation as a little surprising given that the international credit rating agency Standard and Poor's downgraded the outlook rating for the UK government's AAA Sovereign credit to "negative" from "stable". The agency estimated the cost of propping up Britain's banks at between £100 billion and £145 billion and said government debts could double to almost 100 per cent of GDP.

Moreover, the political turmoil which hit the British government in the first week of June when five ministers resigned with many commentators claiming that Prime Minister Gordon Brown is unlikely to remain in office until the next general election is another factor which others have argued does not support the recent recovery of sterling.

The British pound tumbled during the first week of June in the light of these political difficulties but remained resilient in the following weeks. This leads some analysts to conclude that once the political turmoil is over, the pound could have more recovery prospects.

Bloomberg reported on June 30 that British financial historian and Harvard University professor Niall Ferguson suggested the probability of a sterling crisis in the near future. According to Prof. Ferguson, the increase in yields on UK debt from 2.9 per cent in March to 3.6 per cent in recent days is testimony to the doubts about the UK's fiscal stability and the risk premium being demanded by investors.

Despite these comments, most leading international banks expect sterling to remain well supported at this level during the coming months and end the year slightly stronger at £0.82 per €1 but it is widely anticipated to rally during the course of 2010 towards the £0.76 level.

The main reason for this expected strength in 2010 is that the UK is likely to be one of the main beneficiaries of a recovering global economy as UK goods and services remain relatively cheap compared to exports from the euro area and the US. This could give a significant boost to the UK's trade balance later this year and in 2010, potentially providing a significant support for sterling. On the other hand, the key risk to this scenario is that a major part of the UK's public deficit needs to be financed by overseas investors thereby exposing the pound to fragile investor sentiment.

The European Commission forecasts that the UK Treasury will have to borrow 12.75 per cent of GDP in 2010 - more than £10 billion higher than Chancellor Alistair Darling's projections. The EU advised the Chancellor to launch more urgent and radical measures to bolster the UK's budgetary position by either raising taxes or cutting spending. The EU classed Britain alongside the struggling Irish Republic which has one of the most stricken national finances in the world. The UK's public borrowing has now hit a record high of £20 billion.

Some individual economists expect a much bleaker outlook for the UK's budget and indicated the deficit to reach as high as 17 per cent of GDP in 2010. Meanwhile, the overall level of debt compared to the GDP ratio is likely to hit 100 per cent, which is the main reason for the warning by Standard & Poor's that the UK's credit rating could be downgraded. The rating agency explained that this burgeoning level of debt is likely to result in a slower rate of economic growth than widely expected because as the debt level rises, a larger share of tax revenues will be used to pay interest on the debt.

The health of the nation's banking system is also a cause for concern as the performance of the UK economy was highly dependent on the prospects of the financial sector which, as widely documented, saw the nationalisation of Royal Bank of Scotland and Lloyds Banking Group. In recent days, sentiment towards sterling initially turned negative on renewed concerns over Britain's AAA credit rating but then recovered following the publication of the findings of the report issued by the International Monetary Fund (IMF) on the global economy, including the UK.

The IMF sharply revised its previous forecasts on the British economy for 2010. While predicting that the recession in the UK will end this year, the IMF expects the British economy to post a 0.2 per cent growth in 2010.

While this is only a marginal rate of increase, it compared favourably with the IMF's earlier forecast of a 0.4 per cent decline on the back of the expected 4.2 per cent slump in 2009. This lifted sterling to below the £0.86 level against the euro and was further supported after last week's Bank of England decision to maintain interest rates at the existing 315-year low of 0.5 per cent.

So why should the value of sterling remain of importance to local investors? Due to Malta's historical affinity to the UK, many Maltese retain an exposure to sterling. Although this might have diminished in recent years, especially following Malta's adoption of the euro, many Maltese still hold an allocation to the British pound in their investment portfolios and its value against the euro impacts their overall net worth.

On the local Borza, there are two securities denominated in sterling, the equity of 6pm Holdings plc and the sterling tranche of the seven per cent MIDI plc bonds launched at the start of 2009 precisely to attract those Maltese investors who wished to retain their sterling exposure but who were looking for a more rewarding investment following the sharp decline in UK interest rates.

Apart from these two issues, the value of sterling also impacts the fortunes of two other IT companies in Malta due to their strong dependence on business generated in the UK. Crimsonwing plc and Datatrak Holdings plc are both highly exposed to the fluctuations of sterling against euro due to their various contracts with UK businesses.

In fact, both companies warned some months ago that the sharp decline in the value of sterling during the final quarter of 2008 strongly dented their overall revenue figures denominated in euro.

As such, the fortunes of sterling will remain closely monitored by a wide array of Maltese investors and public companies.

Mr Rizzo is director of Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

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