Europe News

British pound undervalued by 15% and could remain so for ‘quite some time’, S&P warns

S&P warns British pound decline may remain for 'some time'

The pound is currently undervalued by as much as 15 percent, of which only 7 percent is due to the post-referendum depreciation, according to a new report by S&P Global.

The report warns that the currency is likely to remain close to its current level for some time after its sharp fall since the U.K.'s Brexit vote in June to leave the European Union.

The recent decline in the currency can be attributed both to expectations that the City of London's weight in the U.K. economy will decline somewhat over time as a result of Brexit, and to vigorous actions taken by the Bank of England (BOE) to soften Brexit's impact on near-term economic growth, the report said.

The currency has seen some major volatility since June. While the initial moves on the day were dramatic, plunging from the highs of $1.50 to a 31-year low of $1.32, the currency continues to remain under pressure at current levels of $1.22. A surprise 6 percent plunge in sterling in the first week of October on fears of "hard Brexit" further added to its steep depreciation. Sterling is down nearly 17 percent against the dollar since the start of the year.

But the pound is accustomed to large swings in its nominal exchange rate, the S&P report said. "Since 1975, the pound experienced eight major periods of decline. On average, those episodes lasted six months, with the pound losing 13.8 percent against the dollar and 18 percent against the euro. The pound's biggest drop against the greenback was in 1981 and again in 1982, which was 19 percent each time."

The report further adds that in the period 2000 to 2007, the growing importance of the financial services industry has pushed the pound's exchange rate away from its equilibrium value, whether measured in purchasing power parity (PPP) terms, or with respect to the adjustment in the current accounts. PPP is when the exchange rate between the currencies of two countries should equal the ratio of the price levels of the two countries, and a current account is a measure of a country's inflows and outflows of goods and services.

While the pound has seen a lot of volatility this year, a number of analysts have said the currency is yet to hit its trough. "We target a move in GBP/USD to $1.20 in three months and $1.15 in six months," Stephen Gallo, European head of FX strategy at BMO Capital Markets, told CNBC via email.

The pound continues to remain under pressure despite enjoying an initial bounce on Tuesday following an announcement by Mark Carney that he will continue to stay on at the Bank of England as governor until 2019. The announcement saw a relief rally pushing the pound around 0.5 percent higher against the greenback but further gains were capped as the currency remains cautious ahead of a BOE policy meeting on Thursday.

"We expect political brinksmanship between the U.K. and the rest of the EU to intensify over the coming three to six months before settling down. For the time being, we expect the BOE to sit on the sidelines in order to avoid triggering a vicious cycle of British pound weakness," BMO's Gallo said.

Meanwhile, the U.K. economy faces the risk of a downgrade if it fails to hold on to its single market access in the EU, ratings agency Moody's warned.

"The UK's 'AA1' sovereign rating would be downgraded if the U.K.'s loss of access to the European single market following Brexit were to materially weaken medium-term growth and if the credibility of U.K. fiscal policy were to be undermined," Moody's said in a statement on Wednesday.

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