What Effect Do UK Elections Have On British Pound?

Britain's modern political environment has taken its shape since the end of WWII. It started with the Labour government of Clement Attlee in 1945, and was followed by the governments of Winston Churchill and other Conservative Party leaders who dominated in the 1950s.

Since then, Labour and Conservative governments have traded off holding power for nearly equal periods during intervals of roughly a decade each.^[1] But how have these governmental changes, particularly the elections, affected the British pound and its stance in the market?

Elections And Strength Of The Economy

At times, it can be difficult to discern whether the levels of currencies are determined as a market anticipation of government economic policies or as a reaction to them. But it is nonetheless clear that the two arenas, politics and the economy, go hand in hand.

Investor perception about the future of economic policies can determine how much investment they are willing to direct toward an economy and thus whether it will operate from a position of strength. Also, the success or failure of policy no doubt reinforces market perceptions about whether an economy is a safe bet for continued investment, thus also determining the political fortunes of public officials who craft policy.^[2]

For the UK, perceptions about the type of policies governments choose to pursue have been critical to the strength or weakness of the pound.^[3]

How Do UK Elections Work?

Britain is a constitutional monarchy and has one of the oldest democratic electoral systems in the world. Under the British system, voters choose their local representatives (known as MPs) to Parliament, and the party with the largest number of MPs has the right to name its leader as the country's prime minister.

The country has 650 parliamentary seats. Most of them, 533, represent regions in England while Scotland has 59 seats, Wales has 40 and Northern Ireland has 18. Each parliamentary seat corresponds to approximately 70,000 voters and more than 98,000 members of the general public.^[4]

Traditionally, parties have needed to get slightly over a third of the popular vote to elect a majority of MPs and form a government. The system, which is known as "first past the post," favours strong, one-party rule, and a strong executive branch. Once a party elects a majority of MPs in parliament, their candidate for prime minister is presented to the queen or king, and sworn into office.

In elections from the late 1970s onward, candidates such as Tony Blair and Margaret Thatcher took on the post of prime minister while representing less than 50% of the popular vote. The key to a prime minister's political strength then often corresponds to the majority they can form in parliament.^[4]

British politics has been traditionally dominated by two main parties: Labour, which has been associated with higher taxation and social welfare spending initiatives; and the Conservative, or Tory, Party that is associated with reduced taxation and greater emphasis on free market initiatives. However, smaller parties have taken a bigger share of the popular vote and improved their prospects for taking more parliamentary seats.

Parties such as the Liberal Democrat Party, the Scottish National Party, the Green Party and the UK Independence Party (UKIP) have seen growing representation and influence in Parliament. With the growth of these parties, chances have also grown that the larger, more traditional parties will need to form coalition governments to be able to build a majority that can approve key economic policy legislation and maintain the faith of markets and investors.

Governments that fail to build strong majority can face the situation of a "hung Parliament" and can be subject to no-confidence votes that require the dissolution of the government before the end of its foreseen term in office.^[4]

Politics And The Pound: A Half Century Of Elections

From the period of reconstruction following WWII until the late 1960s, the level of the pound was fixed against the US dollar at approximately 2.80, reflecting the use of the global gold standard system. Britain had left the gold standard in 1931, but the U.S. had continued to adhere to it until 1971.

The first major movement of the pound against the dollar occurred during the government of Labour Party Prime Minister Harold Wilson. In the midst of 1967, Wilson's government was faced with a difficult scenario of weak domestic demand, growing unemployment, rising oil prices brought by the 6-Day War in the Middle East and sluggish global economic growth. Also, restrictions on foreign investment and investment outside the area of the pound's circulation hurt the country's trade balance.

In an effort to stimulate the economy, the government cut interest rates to 5% from 6.5%. This, however, worsened the trade balance. In a subsequent move, the government raised interest rates by 1%, but investors were not convinced by the move to shore up confidence. In November 1967, the government was forced to allow the pound to weaken to around £2.40 per dollar.

While the pound held stable in the following years, the forced devaluation of the currency left a sense of unease among voters, who chose to throw support to the opposing Conservative Party in the next elections. Wilson actually complained that the conservatives used the matter unfairly, with an attempt to "drag sterling into the campaign."^[6]

But if the Labour government faced difficulties managing the economy, the scenario was not much easier for the incoming administration of Conservative Prime Minister Edward Heath, who took over in 1970. In response to the U.S. suspension of the gold standard in August 1971, the pound began floating freely against the dollar. Initially, the pound regained some strength in wake of the Conservative victory, firming to more than £2.50 to the dollar.

While Heath had campaigned on the idea of introducing austerity policies to government spending, the economy continued to deteriorate and he carried out his famous "U-Turn" on policy, committing instead to heavy government spending in health, education and welfare programs. Heath's government further remained at the mercy of factors outside its control, particularly the impact of the global oil shortage brought on by restrictions imposed by OPEC member countries.

Inflation in Britain spiked to more than 10%, and Harold Wilson took over again in 1974 with a narrow victory for Labour and a slim majority with a "hung Parliament." During his second period as prime minister, Wilson faced internal divisions within the Labour Party. Following defeat of his budget spending proposals by the left wing of his party, Wilson resigned in 1976 and left the prime minister's post to Home Secretary and former Chancellor of the Exchequer James Callaghan.^[7]

However, the government's internal disputes surrounding the budget and continued high inflation helped convince investors that the pound was overvalued, and the currency plunged to a low against the dollar that year of around £1.60. To resolve its budget difficulties, Callaghan's Labour government negotiated a $5.3 billion standby loan with the U.S. Treasury, and then a $3.9 billion loan from the International Monetary Fund, the largest of its kind at that time.^[7]

Following the approval of the IMF loan, the overall economic outlook improved. Interest rates were reduced and the pound appreciated in value to previous levels of around £2.50 per dollar. By 1977, there were also improvements in the country's trade balance, due in part to new oil revenues. However, the period of economic weakness seen over the previous decade had left its mark, and the country was overtaken by strikes and labor unrest in what was later called the "winter of discontent."

The general dissatisfaction with the state of the economy left an opportunity for the Tories, leading to the victory of Margaret Thatcher in the 1979 general elections. In an effort to debilitate rampant inflation and encourage renewed investment in the economy, the Thatcher government abandoned the exchange controls system that had been in place in the UK since the 1940s and adopted a "monetarist" approach aimed at controlling M3 money supply.^[8]

Unemployment and inflation, which had both reached more than 20% under the previous Labour government, fell to below 15% and 10%, respectively, in the following years. However, by 1985 the pound plummeted to a record low of around £1.05 to the dollar. It was in reaction to diminished prices of UK oil exports and a strong demand for dollars globally prompted by tight money policy, elevated interest rates and expanding credit offering in the U.S.^[8]

European Exchange Rate Mechanism

The struggle for political power also came into play during the UK's brief participation and forced exit from the European Exchange Rate Mechanism (ERM), which tied the pound to inflation parameters in Europe. British Chancellor of the Exchequer Nigel Lawson supported the participation, because he believed it would provide an anchor for Britain's monetary policy. However, Thatcher opposed the measure, because she believed it would expose the pound market to excessive speculation, especially during times of general elections.^[9]

Amid a scenario of high interest rates and slowing growth Thatcher was challenged for her leadership within her party and relinquished command to those in favour of the participation in the mechanism. The UK began participation in the ERM in 1990 under the leadership of Thatcher's successor, John Major. By September 1992, however, facing a speculative attack against the currency, the government was unable to maintain the pound above an agreed lower limit within the ERM. As a result, it was forced to drop out of the mechanism.^[9]

Recent History: Overcoming Uncertainty

The period following the Thatcher government and the lifting of exchange controls has shown clear patterns for how the pound behaves before, during and after general elections. The policy tendencies of each of the major parties aside, the best indicator of whether the pound will attract investors and maintain its relative strength against other major currencies may be the following:

• The size of the majority that the parties can obtain in Parliament, and
• The certainty among investors that economic policy proposals will receive backing.

Generally, trends ahead of the elections have shown some speculative movement, with the pound losing ground against the dollar, only to strengthen afterward.

In the 1992 election, which re-affirmed Thatcher's successor John Major in power, the pound slipped more than 3.5% against the dollar ahead of the election, and then gained more than 7.5% against the greenback in the period following the election.

In the 1997 election, which brought moderate Labour candidate Tony Blair to power, trends were more muted. The pound gained about half a percentage point against the dollar before the election and continued the trend with a slight 0.2% gain in the period following the election.

The swings resumed in Blair's 2001 re-election, with the pound weakening more than 4.5% ahead of the polling and gaining back the same amount afterward.^[10]

In 2005, with the election of Labour candidate Gordon Brown to office, the trend was reversed entirely. The pound gained 2.7% against the dollar ahead of the election and weakened by more than 6.5% in the period following the election. But Brown, who was perceived as sympathetic to participation in the eurozone, was later credited with maintaining the country out of the zone due to a preference for maintaining independent UK economic policy.^[11]

In the 2010 election of David Cameron and the return of the conservatives, the more traditional pattern resumed. The pound weakened by 5% before the election and gained back 7.5% in the following months. The pattern also held in Cameron's re-election in 2015, with the pound gaining 1% against the dollar.^[10]

EUR/GBP: A Different Dynamic

Unlike the dollar market, less speculation has appeared to take place in the EUR/GBP pair around the time of elections. Since the 1990s, the euro has most often shown a net gain against the pound around the time of elections. In many of those cases, the EUR/GBP pairing has shown the opposite movement of the GBP/USD pair, with the pound strengthening against the euro ahead of the elections and selling off afterward.^[10]

Long-Term Weakening?

According to some analysts, the GBP has been on a trend of long-term weakening over the past century independent of the ups and downs of government policy and market sentiment. Under this theory, the UK's economic influence has been waning as other major currencies, such as the euro and the Chinese renminbi, have grown in importance. While the pound served as the premier international reserve currency a century ago, it now represents only about 5% of reserve holdings of central banks around the globe.

Some analysts have more recently pointed to the approval of Britain's exit from the European Union, or "Brexit," as a sign of the consolidation of that trend. They note that Britain may lose some access to the large European market and also lose its status as an international financial center that serves as a hub for trading for Europe and other regions of the world.^[13]

Volatility

The trend for the pound ahead of elections may depend greatly on the situation at the moment they take place. However, one thing past charts tell us is that traders can most often expect volatility during election periods, especially in the GBP/USD pair. Prices swings of 8 to 10 percentage points have been common during periods before and after elections. This means that when traders are capable of identifying trends ahead of an election, they may stand to gain if they are prepared to ride out the trend through the election cycle and into a period of stable governance.^[10]

The Brexit's Effect On The Pound

A great amount of uncertainty has surrounded the future of the British economy, investment and the strength of the pound since the narrow vote to end the country's direct participation in the European Union (aka the aforementioned Brexit).

The result of the referendum prompted Conservative Party Prime Minister David Cameron to step down from his post and relinquish it to Conservative colleague Theresa May. The vote caused some immediate panic for global investors in Britain. They concluded that investments in UK assets, such as banks, would lose value if the country lost its easy access to European financial markets with the separation.^[14]

At the same time, global investors sold the pound, which sank to 30-year lows of below £1.30 per dollar in the period following the referendum. However, the referendum's ultimate impact on the strength of the pound may depend on how May is able to carry out her mandate to administer the Brexit before the country's next general elections scheduled for 2020.^[15]

Summary

The pound has undergone a general trend of weakening against the dollar and other major currencies ever since the world went off the gold standard in the 1970s and the currency was allowed to float against its peers on the world market. However, British governments have worked to reinforce the country's reputation as a safe haven for global financial investment amid perennial political and economic uncertainties in other regions of the world.

This tradition alone may suffice to maintain the pound as a relatively strong currency among its peers, despite short-term market interpretations and movements that can occur during the period of general elections.

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