In the 60s and 70s, of course, such things mattered enormously. But it seems that times have changed. Since 1985, the correlation between the current account balance as a share of GDP and the level of sterling’s trade-weighted index has been a statistically insignificant -0.12. For example, sterling’s biggest quarterly fall - at the end of 2008 - came at a time of only small deficits.
However, it does not follow that the current account is irrelevant. Although there's no contemporaneous correlation between sterling and the current account, there might be a lagged correlation, in two opposing ways.
One possibility is that sterling can move because of expectations of future deficits or surpluses. For example, the pound fell in 1986 as oil prices fell, because markets anticipated that the lower oil price would reduce the UK’s export earnings from the North Sea. Similarly, you could argue that part of sterling's fall in 2008 was due to markets anticipating that a smaller banking sector would reduce the UK’s overseas earnings from financial services.
Sterling can therefore move before the current account does. But there's an alternative mechanism which suggests it can also move after it. This is the portfolio balance effect.
The current account deficit means that there is more demand for overseas goods and services than there is for UK ones. This means there's a tendency for there to be stronger demand for foreign currency - to pay for those foreign goods - than there is for pounds. This should tend to depress sterling. So, why doesn't it? It's because the excess demand for foreign currency arising from goods trade can be offset by a demand for sterling arising from asset trades. If foreigners are happy to buy UK shares and bonds or (what amounts to the same thing) if UK investors want to sell foreign assets, then demand for sterling can be high, and so a deficit on goods and services trade needn't cause sterling to fall.
However, if the UK runs a series of current account deficits it needs increasing net demand for UK assets to sustain demand for sterling. Such demand might not be readily forthcoming. If it isn’t, then sterling will fall to a level at which UK assets seem sufficiently cheap to attract buying. (The balance of payments, of course, must always balance with a current account deficit being offset by a capital account inflow. The question is: what level of the exchange rate is needed to attract that inflow?)
This is no mere theory. It's what happened in the late 80s and early 90s. In 1988-89 the UK ran large deficits but sterling held up well before falling in the early 90s, as investors became unwilling to hold an increasing stock of UK assets.
Herein, though, lies our dilemma. These two mechanisms have opposing implications for sterling. The fact that sterling has held up well suggests that markets expect the large current account deficit to be only temporary. That's no problem for sterling. However, the portfolio balance mechanism implies that the deficit will be a threat to sterling if it continues - though we can't say when or by how much it will fall. As Sushil Wadhwani, a former member of the monetary policy committee once said, "deficits appear not to matter until, well, they suddenly do!"
The message I take from this is that forecasting exchange rates on the basis of macroeconomic forces is a mug's game. It can't be done - at least not accurately enough to make money. The most important fact about exchange rates for investors is the Meese-Rogoff puzzle.
What we can say, though, is that exchange rate volatility is such that there's a good chance of sterling falling, whether the current account matters or not. In the last 20 years, the annualized volatility of sterling's trade-weighted index has been just over seven per cent. This alone implies that there’s an eight per cent chance of sterling falling 10 per cent or more over a 12-month period.
