Politics and the Pound: The Complexities of an EU Referendum Will Rattle Nerves

At the beginning of this year, the view was that sterling would face significant risks from political developments in the course of 2015.  First, there was the risk that the general election, scheduled for 7 May, would result in a Left-leaning Labour Government or, possibly, an irremediably ‘hung’ Parliament. Even if the Conservatives came out on top, there would then be the further risks associated with their promise to hold a referendum on the UK’s EU membership.  Sterling’s relative strength as 2015 opened was not expected to persist far into the year.  We shared the general leeriness over the pound’s prospects but so far the UK currency has, if anything, been firmer than is good for the economy.  At the end of 2014, sterling was already 13% stronger than its March 2013 low point.  By 7 May, it had appreciated a further 1.2% overall.  Admittedly, there had been a small wobble leading up to the election as concerns grew that the Conservatives were not making their expected breakthrough in the opinion polls.  But a decline between 28 April and 6 May was modest and left the pound still stronger than it had been at times in March.  In two days following the election result, these pre-election losses were more than reversed despite purported worries over the UK’s EU status.

political risk surrounding the UK could yet carry THE POUND lower

To be sure, a case might be made that the pound would have been stronger still, had it not been for the political risks. Such an argument might rest on the significantly positive interest rates that the UK currency offers, a rarity in Europe nowadays.

Despite the pound’s present buoyancy, a growing perception of political risk surrounding the UK could yet carry it lower. The question is one of timing.  It may be far too soon to expect currency market traders, whose horizons are increasingly foreshortened, to discount a UK rupture with the EU that may not occur until 2017, if it happens at all.  Businesses drawing up medium-term capital investment plans, on the other hand, may feel they have to take fully into account the risks of a politically-triggered sterling decline even if it happens two years hence. Initial indications of their concern may show in the long-term capital account of the UK balance of payments rather than in the sterling exchange rate.  Any marked deterioration in the long-term capital balance might portend a weakening in sterling.  Consequently, it is not too early to begin to assess the likely course and outcome of the British  Government’s negotiations over reform with its EU partners.

At first glance, we might wonder why there is so much fuss about a prospective EU referendum.  Most recent opinion polls have shown a majority of UK voters in favour of staying in the EU, with roughly 45% saying they would vote ‘in’ and 35% ‘out’ if there were a vote now.  We might also wonder, though, whether the polls are any more accurate in gauging public opinion on the EU referendum than they were in predicting the election outcome.  

 voters may be disappointed with the ‘reforms’ the UK prime minister will be able to bring back from Brussels

Even if the polls on EU membership are accurate, public opinion appears to be volatile.  In the early months of 2013, the polls registered consistent ten-point majorities in support of leaving the EU.  How it will look another two years on may be anyone’s guess.  Then again, and deepening the uncertainty surrounding the poll results, there is a large number of undecided voters, around 20% of the electorate, together with a large proportion saying it is unlikely they would vote.  Whether voters really would remain as apathetic as the polls now suggest during an ‘in-or-out’ political campaign is open to some doubt, seeing the whole nation might succumb to ‘referendum fever’ as Scotland did last September.  Furthermore, among those members of the poll sample saying they would vote to stay in the EU, there may be many who assume that David Cameron will be able to wrest substantial concessions from his EU partners.  In the event, some of these potential voters may be disappointed with the ‘reforms’ the UK prime minister will be able to bring back from Brussels.  The Government may feel it can count on swinging support in favour of its preferred course in any future EU vote.  After all, in the 1975 referendum, the political establishment was easily able to secure a ‘Yes’ vote to the EU by virtue of the authority it then enjoyed.  Nowadays, though, the views of established political leaders may likely be more toxic to the cause they embrace, so low has public trust in them sunk.

Before the election, Mr Cameron focused demands for EU ‘reform’ on curbing immigration of EU nationals into the UK.  This reflected his anxiety to stem UKIP’s inroads into the Conservative electoral base.  But one reason why UKIP made immigration a central issue is that its leaders were well aware that no solutions to the problem would be compatible with the UK’s continued EU membership.  In seeking ‘reform’ in this area, Mr Cameron is proposing that EU immigrants should not be eligible for out-of-work state benefits, but very few of them do collect those benefits in any case.  Many more are in low-wage occupations with incomes topped up with tax credits, an arrangement Mr Cameron’s EU partners will insist should continue.  Any tightening of UK rules in this regard would interfere with the cherished principle of free movement of labour within the EU.  Then again, Mr Cameron is suggesting the UK should have an opt-out from the ‘ever closer union’ goal towards which the EU is, in principle, moving.  But such a provision, even if guaranteed by treaty, would not preclude some degree of closer union. UK voters may well imagine the object of Mr Cameron’s endeavours is to roll back some elements in the UK’s EU participation that are already in place.  Mr Cameron’s limited demands could lead to a set of ‘reforms’ that fall well short of voters’ current expectations.

As the true complexity of the choice facing voters emerges, so the increasingly apparent risk of an unexpected turn of events

The UK prime minister could probably take a bolder line, if he wished.  Last week. Sigmar Gabriel, Germany’s Economics Minister, declared, ‘when the first country leaves [the EU], the world will view Europe differently.  No one will trust us if we fall apart after the first challenge’.  He was speaking in the context of a possible Greek exit from the euro zone and EU.  His view is probably in line with the consensus of EU political leaders, which is why negotiations with the Greek government drag on, despite few signs of co-operation from Athens.  But how much more serious a blow to the political credibility of the EU it would be if the UK were to leave. Whatever solution were found to resolve differences between the UK government and the EU authorities, the latter would want to describe the situation as the UK’s remaining within the EU.  The Cameron Government would also probably like to be able to say that negotiations with EU partners had ended with an agreement that allowed the UK to preserve its national interests while staying ‘in’ the EU. That would help calm the anxieties of foreign investors in the UK who might otherwise take an overly dramatic view of any change in relations between the EU and the UK.  Philip Hammond, the UK foreign secretary and a self-styled euro-sceptic, said last week that he hoped talks would end with a good package of reforms, on the basis of which he would campaign for an ‘In’ vote.

Clearly, there is a wide range of ‘reform’ proposals to which an ‘In’ vote could represent assent.  Also, contrary to pro-EU propaganda, there is a broad spectrum of loose associations the UK might enjoy with the EU, where it would be a matter of semantics whether or not they were labelled as membership of the EU.  A ‘simple in-or-out’ referendum is an impossibility, given the current and likely future complexity of relations between the UK and the EU.  What will matter is how many powers, if any, Mr Cameron’s negotiations succeed in repatriating to the UK and how the resulting situation is presented to voters. The market imagines there will be a ‘simple in-or-out’ question.  As the true complexity of the choice facing voters emerges, so the increasingly apparent risk of an unexpected turn of events is likely to strain the nerves of sterling holders.

More about the author

About the author

Stephen’s career spanning five decades has made him one of the most respected and unique voices in the City of London. Disclaimer regularly publishes a selection of his elegant and thoughtful essays on the global economy, which he has been writing regularly since he founded Fifth Horseman Publications in the late 1980s. As well as an economist, Stephen serves as Treasurer of the Forum for European Philosophy and was elected to the Royal Institute of Philosophy.

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