Pound Woes: Why Britain's Currency Is Falling

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Shaun Curry / AFP / Getty

Asked to name the beleaguered Western currency that sits near a 10-month low against the dollar and has lost 7% against the greenback already this year, most people would probably plump for the euro. They'd be wrong. Europe's single currency — walloped by the big economic problems in Greece — is hardly having a stellar year. But for a currency well and truly in the pickle, look no further than the pound.

There's pressure on sterling from all sides. The currency fell below $1.50 for the first time in 10 months on Monday after an opinion poll published in a British newspaper suggested that none of the parties contesting the country's upcoming general election would emerge with overall control. A so-called hung parliament, investors deduced, would not likely result in a clear plan to tackle the country's dreadful public finances.

Also a factor in Monday's slide: plans announced by Prudential, a British insurer, to buy the Asian operations of AIG for an eye-popping $35 billion. Much of that would be paid in cash, Prudential said, which would mean swapping huge piles of sterling for dollars. Toss in the relentless pressure from speculators betting on a falling pound, as well as Britain's generally horrible fiscal position, and "sterling has sailed into a perfect storm of negativity," Nick Beecroft, a senior foreign exchange consultant at Saxo Bank, wrote in a research note earlier this week.

The good news for Britain's pound: nasty fronts like this are usually rare, and soon pass. For one, the slide likely had more to do with Prudential's announcement than with intensified concerns about hung parliaments, as was reported widely in the British press, says Daragh Maher, deputy head of global foreign exchange strategy at Credit Agricole in London. In some ways, that's encouraging. If a single opinion poll was able to trigger the kind of slump seen Monday — in a volatile day of trading, sterling eventually closed 1.7% down on the dollar — an actual hung parliament might be expected to cause the venerable currency to collapse. And while it's true that speculators are adding to the pressure on sterling — the value of short positions on the pound rose to more than $6 billion in the week prior to Feb. 23 — they remain "the froth at the top," insists Simon Derrick, head of currency research at Bank of New York Mellon in London.

It also helps explain why sterling has stabilized since the steep fall on Monday. The pound actually rose slightly against the dollar on Wednesday amid reports the Prudential deal was floundering and the release of data showing a rise in U.K. consumer confidence last month.

But that's not to say a hung Parliament itself wouldn't hit the pound hard. Long viewed as almost certain winners of an election expected in May, the Conservatives have squandered their double-digit lead in recent weeks. In fact, in a YouGov poll published in Britain's Sunday Times on Feb. 28, the Tories' margin over the governing Labour Party had diminished to just two percentage points, raising the specter of no party winning absolute control of Parliament. The problem: Britain has had little practice at coalition government in recent years. Its last attempt — more than 30 years ago — has done nothing to help sell the idea now. A hung Parliament could see a second election called in a matter of months. And all the while, Britain's $268 billion deficit goes unchecked.

Of course, investors' nerves are based on the idea that a clear election winner would create the best conditions for tackling that treacherous shortfall. While it's a reasonable assumption, it's hardly foolproof. Prime Minister Gordon Brown has little credibility left when it comes to the economy following his stint as Britain's free-spending Finance Minister in the decade leading up to the financial crisis. And although the Conservatives have pledged immediate cuts to the deficit should they win, they're still light on detail.

Which makes the backdrop to the pound's latest dip — the massive public debt and deficit, and the potential threat to Britain's triple A investment rating — a far greater problem for the currency than anything else. The rest is small change.