Currency crises are not limited to emerging markets, as demonstrated by the U.K. these past few weeks. In fact, several developed countries have seen significant devaluations in their local tender during my 32 years in the markets. I witnessed my first home, Canada, suffer a currency devaluation of almost 5% annually from 1991 to 1998. During that same decade, Italy provided numerous opportunities to buy premium fashion brands at 50% discounts in those pre-euro days. The Italian lira lost 30% in 1992 followed by another 17% in 1993, but the lira's decline vs. the U.S. dollar over that period pales in comparison with the lira volatility of the '80s. Even the Japanese yen, Australian dollar and Germany's deutsche mark had their moments.
A sudden currency crash brings home the immediacy of the problem more palpably than analyzing the long-term effects of interest rate differentials (nominal and real), current account balances and the terms of trade on exchange rates. When viewing countries from a micro lens or company perspective, currency movements are more explainable. Seeing the U.K. economy instead as one of the thousands of small and medium-sized businesses that make up more than 60% of the employment of "U.K. PLC," and the currency reaction makes perfect sense.
Start with substituting the country's leaders for company management. The president or prime minister is the CEO, the finance minister is the CFO, and so on. A country's accounts become its income statement and balance sheet. Broadly, revenue (tax) is the royalty the government collects from all participants to use its infrastructure and resources. Expenses are the costs of running the government and public services. Provided there is no change in the tax rate, a country's revenue grows with gross domestic product, which the government uses to increase public services or allocate to infrastructure the same way a company can provide more employee benefits or expand its plant, property and equipment, or PP&E. The publicly traded stock of the country is its currency and it can fund itself through excess cash (revenue>expenses), issuing debt or selling stock (printing money).
If we apply this model to the latest currency debacle in the U.K., it becomes apparent why investors sold the currency (stock). The original fiscal plan of "CEO" Liz Truss, who just announced her resignation, and her now ex-"CFO" Kwasi Kwarteng, was going to reduce the royalty (tax) rate, decreasing revenue in hopes that by giving consumers more money they will spend more, eventually boosting revenue (taxes). This is analogous to a company cutting the price of its products in hopes that people will buy more (trading price for volume). As Ms. Truss and Mr. Kwarteng hadn't detailed any cost cuts, the country would have needed to borrow or sell stock (print money) to fund their initiative. If they decided to borrow, the interest expense would have been an additional increase to their overall cost base.
Let's pause for a moment and reflect on how a lender in the business world would react to a small business owner asking to borrow money so it could reduce the cost of the product, betting that customers would buy more and eventually increase sales. Or how the stock market would react to a CEO who announces at the quarterly call that the plan to increase sales is to initially cut them without a reduction in costs. Borrowing costs would soar and the stock price would collapse. Surprises and uncertainty scare investors, and this is exactly what happened in the U.K. In the past three decades, the only event comparable to a credit crisis is a loss of investor confidence (for example, the U.S. corporate scandals involving Enron and Arthur Andersen). Ms. Truss severely dented investor confidence, causing her stock (currency) to drop and lenders to ask for higher rates. It's a timely reminder that one should never count on the goodwill of others to meet obligations.
The price/volume strategy is well-tested with mixed results, and rarely is it attempted with leverage. Missing from the initial Truss plan was how long it would have taken to reap the benefits. Success is time sensitive. How quickly can companies pump sales and survive? Those that fail the test of attracting new sales early have met with disaster. The trouble with a big company like U.K. PLC is the sales cycle is measured in years. The initial proposed tax cut might not have shown results for 12 to 24 months. And there was a real risk that consumers would choose to save rather than spend.
This strategy would have halted any investment in infrastructure or maintenance capital expenditures that are essential in most companies. That's even more the case in companies—and countries—that need to maintain their existing plant, property and equipment while investing for the future. Aging stock and run-down machinery do not serve companies or countries well. Investing in long-term infrastructure projects produces durable returns, which would have been sacrificed. In the end, the costs of this strategy would not have been limited to additional interest expense but the depreciation of the country's assets and benefits from innovation.
Lastly, Ms. Truss and her management team should have been aware of one of the cardinal rules of product sales: Use price cuts only as a last resort in an effort to boost revenue. A product sells because of its features. Was CEO Truss telling the world that U.K. PLC had nothing else to offer?
Written by Scott Davies
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