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Overview, Knowing the British Pound,

Overview of the UK Economy

One of the most important features of the UK economy include a mammoth GDP of about US$1.867 Trillion (2005), which places it at 7th place in world rankings. The highlights of the UK economy are: a robust banking & finance sector, very healthy consumer consumption, phenomenally low unemployment, a very strong service sector, expanding Energy (natural gas) sector, lower dependence on manufacturing and an increasing overall output. Though the Service sector is currently dominating, the growth rate of Housing markets has been astounding with no signs of retardation. The UK carries out bulk of its trade with the US and the European Union (more than 50%). UK also stands to gain from the shooting up of global oil prices as it exports oil and natural gas in large proportions.

Regulatory Authority - The Bank of England (BoE)

The Bank of England frames and implements the monetary policy for UK through its Monetary Policy Committee (MPC). Under the act of the British Parliament in 1997, the BoE was made an independent body & dislodged from the influence of the Treasury. The primary objective of the BoE is to ensure that inflation remains under control and & achieve the Government's aims of growth & employment. It also seeks to maintain a stable financial system for the UK and ensure effectiveness of UK's financial services. The BoE considers a value of 1.75% on HICP (Harmonised index of Consumer Prices) as the healthy inflation target. The MPC comprises of the Governor, the deputy governor, two executive directors of the bank and four experts from outside the bank. The Statements of the MPC after its Monthly Meetings, its Quarterly Inflation Report and Quarterly Bulletin provide information about inflation, possible policy adjustments, analysis of UK's economy vis-a-vis world economies, justifications on past policy changes and forecast for future economic growth.

The main methods adopted by the BoE to implement the monetary policy are:

Setting the Minimum Lending Rate (Base rate)

The Base rate is the rate of interest charged for lending and borrowing activities by the bank. A rise in this rate is required to limit an increase in inflation while reduction in this rate is necessary to control deflation by encouraging growth & investments. The BoE can changes these rates during its monthly review (first week of every month). Changes in the interest rates are known to significantly impact the Sterling as it directly influences the rate of return on investments in the UK.

Implementation of changes in Bank rate

Changes in the Bank rate are put into practice through open market operations of the bank, which involves purchase and sale of short-term government fixed income instruments. This is done without compromising the market liquidity and stability of the banking system.

Knowing the British Pound and its influencing factors

High Liquidity
There are two primary reasons for the phenomenal liquidity of the British Pound. First, UK is the one of the top investment destinations after the US, for international investors. All such investments would require conversion of their currencies to GBP. Second, GBP/USD pair is a highly traded currency pair and accounts for 7% of net Forex trade.

Effect of Carry Trades

With the GBP offering very high interest rates, international investors park their funds in the UK after selling their investment in other countries. This is called 'Carry Trade'. A Carry Trade involving purchase of British assets results in appreciation of the GBP.

Effect of difference in interest rates of UK Gilts & international bonds

This is same as the effect of Carry Trade except that in this case, instead of financial market investments, the UK Govt securities (Gilts) are involved. If the interest rate of UK Gilts is higher than German Bunds & US Treasury, then the demand for the Sterling would increase and consequently lead to the rise of the GBP vis-a-vis other currencies.

Forecasting through the 3 month EuroSterling futures

One can come to know about the market expectations on the interest rate of Eurosterling contracts 3 months in future. They are used to forecast the UK interest rates, which consequently would affect the exchange rate of the Sterling.

Effect of comments by politicians on joining EMU

Any indication from influential politicians favouring the adoption of Euro as the UK's currency causes a negative impact on the GBP, causing it to depreciate. This is again because of the Carry Trade effect - foreign investors are hanging on to their British assets only due to its high rate of returns. But, if the Euro, with only 2.75% interest rate is adopted over the GBP with 4%, they would withdraw their funds, causing the sale of their GBP and consequently its depreciation due to fall in its demand.

The Oil Markets

The UK is rich in oil wealth with a contribution of about 11% to its GDP and the GBP tends to appreciate with a rise in global oil prices. This is because the demand for GBP would increase, as more GBP would be required by other countries to buy oil from UK.

The effect of Cross Rates

Any changes in the EUR/GBP conversion rate will affect the GBP/USD conversion rate and vice versa if the EUR/USD rate is maintained constant. This is due to pure mathematical reasons, as the division of EUR/USD rate by GBP/USD must equal the EUR/GBP rate to achieve arithmetic consistency. This phenomenon also leaves traders with opportunities to make easy money by quickly trading the above pairs with momentary inconsistencies until the rates are set right by the markets.

The key Economic Indicators for UK include GDP, Unemployment rate, Balance of Trade, HICP, Retail sales, Consumer's earnings, PPI, & Housing prices apart from BoE Data.

Overview, Knowing the British Pound,



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