Trying to quantify risk is rarely an easy task. It is usually necessary to estimate at least two independent variables:
• the probability of an event happening in the future; and
• the impact of that event on whatever dependant variable we are interested in.
By combining these two variables together, we can begin to approximate risk.
Usually, it is the probability estimate that causes the biggest problem. As we are not able to predict the future, we must try and come up with estimated probabilities of future outcomes – based on some combination of analysis, gut feel and other tools such as prices, polls and betting markets.
The estimate of impact is typically easier, as we are often dealing with a deterministic relationship between the event and the impact of the event; whether or not it will rain tomorrow is a question of probability, but the fact that a thunderstorm will cause our picnic to be cancelled is pretty much a nailed-on certainty.
However, when it comes to evaluating the possible effects of the UK exiting the EU, our task is made doubly hard by the fact that – even if we are able to come up with some estimate for the probability of Brexit – there is still a high degree of uncertainty about its impact on the British pound (GBP). This is due to the fact that there are many other factors that will impact on the value of the currency, such as the future path of UK monetary policy, the demand for UK assets by foreigners and the UK’s economic performance.
Let’s start with probability though. There are a number of ways of trying to estimate the chances of a ‘Leave’ vote in three months’ time. One method is to look at the polls, which although discredited somewhat in the recent UK elections, do represent the only direct measurement of current voting intentions. Of the last 10 polls conducted, four of these suggest the ‘Leave’ side winning, while five favour the ‘Remain’ camp, with one tie. This suggests about a 40% probability of Brexit occurring.
A second, arguably superior, approach to estimating the probability is to look at the betting markets. These have historically been a more accurate indicator than polling when it comes to predicting elections and referendums. Current betting markets suggest that the probability of a vote in favour of Brexit is actually a little less than that indicated by polling, at around one in three.
A final approach is simply to listen to the supposed experts. If we look at the major banks, we can get a range of views about the probability of a Brexit, ranging from about 1 in 3 (for example, HSBC) to about 45% (Société Générale). Once we put these three methods of estimating probability together, it looks like the odds of a vote in favour of Brexit on June 23rd range from about 33% to 45%.
Predictions for the pound
So, what about the impact of Brexit on the pound? As discussed, it is very hard to quantify such an impact on an ex ante basis, as there is no direct causal link between a Brexit vote and the value of the pound. Furthermore, the latter depends very much against what you are valuing it. It is entirely possible – perhaps even likely – that the effect of Brexit on GBP against the dollar (USD) will be quite different from the effect on GBP against the euro (EUR).
However, what we can assume is that a vote for a Brexit would be considered a significant market shock for the pound, at least in the short to medium term. This could be expected to generate considerable selling pressure on the currency, as investors eschew UK markets for a period of time until the impact of Brexit on the economy and on financial markets becomes clearer.
There are a couple of ways to gauge the magnitude of this shock. The first relies on an estimate of the ‘fair value’ of the currency, which is a metric based on the idea that the purchasing power of a currency represents its ‘real’ value versus its peers. Deviations from this fair value can and do occur of course, and can sometimes persist for years, although the fair value of the currency does tend to provide an anchor of sorts to the exchange rate.
GBP-USD is currently trading very close to its fair value against the USD (fair value is approximately 1.40 – 1.45 on most measures). Looking back over time, deviations from fair value have rarely exceed +/-20%. As such, one way of looking at the potential impact of Brexit would be to assume that it could push the pound towards this extreme – in this case, a GBP-USD exchange rate of about 1.15 – 1.20.
Another approach is to assume that Brexit would cause a currency crisis for the pound. This is not as far-fetched as it might sound; the UK exhibits a number of factors which make it susceptible to a such a crisis; in fact, if you rank the G7 and the so-called ‘Fragile Five’ (Brazil, South Africa, India, Indonesia and Turkey) together according to combination of current account deficit and budget deficit (from lowest deficit to highest), the UK finishes joint last (tied with Brazil) out of the 12 nations.
A currency crisis is typically defined as a depreciation of more than 25%. During the 2008-09 global financial crisis, 23 countries experienced such a devaluation against the USD, and the average magnitude of this devaluation was about 43%. Such a devaluation (from 30% – 43%) would potentially take GBP-USD below parity (to between $0.82 and $1.08). Sounds extreme? Well, it is – however, the pound has shown similar devaluations on three previous occasions since the Bretton Woods conference 72 years ago and the introduction of the global system of floating currencies. So such a move cannot be discounted entirely.
There are a couple of important conclusions we can draw from this analysis:
1. The probability of a Brexit is very real (it is certainly higher than the probability of a Donald Trump presidency, for example, which is currently estimated at about 25%, according to the betting markets);
2. The impact of a Brexit on the pound will likely be material, at least in the near term.
Theodore Roosevelt once noted that ‘risk is like fire: If controlled it will help you; if uncontrolled it will rise up and destroy you’. While a devalued pound might help many UK exporters and GBP-based investors, the currency market volatility that potentially will be unleashed in the event of a Brexit vote on June 23rd might indeed be destructive.
For corporations and investors with exposure to the British pound, the potential value of a robust risk management infrastructure and an agile hedging strategy has never been greater.
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