More vulnerable than it appears.

Photographer: Chris Ratcliffe/Bloomberg

A Lehman Lesson for the British Pound

Mark Gilbert is a Bloomberg Gadfly columnist covering asset management. He previously was a Bloomberg View columnist, and prior to that the London bureau chief for Bloomberg News. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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Here's a party game for anyone interested in the interaction between politics, economics and financial markets: Guess how much value the British pound will lose in the wake of the June 23 referendum if the U.K. votes to exit the European Union?

The most recent opinion poll puts the pro- and anti-EU camps running neck and neck at 39 points, leaving the "don't knows" with the power to dictate the outcome at 22 points. So the outcome is far from clear.

The Brexit Debate

The Bank of England said this week that the uncertainty is already undermining investment appetite. World Bank President Jim Yong Kim warned that the economy "is not going to do well with more uncertainty." And investors typically shun the currencies of countries with ambiguous political or economic outlooks.

The pound is already the worst-performing Group-of-10 currency against the dollar this year, with a decline of about 4 percent. So what do previous currency-market ructions tell us about the potential for post-referendum declines for the U.K. currency?


In the run-up to the introduction of the euro, Europe had a currency management system called the Exchange Rate Mechanism, within which currencies traded against each other within pre-established corridors. Britain was a member of the ERM but, on Sept. 16, 1992, the government abandoned its efforts to keep the pound trading in a range around a central target of 2.95 deutsche marks.

The currency had already been hovering near the bottom of its permitted trading range, and was valued at 2.81 marks by the time the government capitulated, a day dubbed "Black Wednesday" by the press. In the next three weeks, sterling lost 14 percent of its value, and was worth just 2.41 marks:


Opinion polls in the approach to the 1992 U.K. election showed the Labour Party consistently leading the governing Conservative Party, which had won the previous three elections. Investors were concerned that a new government might increase borrowing and accelerate spending, as past Labour administrations had been wont to do.

So as the exit polls and results on April 9 started to trickle in showing a fourth consecutive Conservative victory, investor appetite for U.K. securities quickly recovered. The yield on the 10-year U.K. government bond, which had started the month at 10 percent, had dropped to 9.2 percent by the time trading closed on April 10. And the pound, worth about 2.84 deutsche marks on the eve of the election, gained as much as 3.5 percent in the next three weeks and climbed to 2.94 marks:


In the second half of 1998, Russia was struggling to find the money to pay more than $23 billion it owed to holders of its ruble-denominated debt. Its foreign-exchange reserves were dwindling, and requests for additional aid following a $22.6 billion rescue package led by the International Monetary Fund were rebuffed by Group of Seven nations. 

So on Aug. 17, the government announced that it was suspending repayment of $43 billion of short-term debts and devaluing its currency. The ruble had been trading at about 6 rubles per dollar (the corollary being that one ruble would buy about 16 U.S. cents. By Sept. 8, it had dropped to about 21 rubles per dollar (a move of more than 200 percent) and bought a bit less than 5 cents (a depreciation of about 70 percent):


As the derivatives edifice built on rotten subprime mortgages started to crumble in 2008, it rapidly became apparent just how interconnected the world of finance was. If the collapse of Lehman Brothers on Sept. 15 was the butterfly, then the storm that hit a part of the market called the carry trade was the ensuing tornado.

The carry trade involved borrowing a currency with a low interest rate -- the Japanese yen, for example -- to invest in one paying a much higher rate of return -- the Australian dollar, for example. Lehman's demise, though, killed off liquidity throughout the markets, forcing traders unwind carry trades that had already been in trouble as the credit crisis worsened and prompting a drop of 40 percent in the Australian dollar's value against the yen in just six weeks:


Traders are already speculating on post-referendum swings in the pound's value against the dollar, with implied volatility in the options market surging this year to double its average value in the past five years:

What do all these examples tell us about Britain's situation today? On one level, very little: Just as every unhappy family is unhappy in its own way (as Leo Tolstoy pointed out), so every currency crisis is unique.The sustainability of the pound's ERM rate had been questioned for months, and it wasn't only George Soros who was betting against it. The 1992 election outcome was a surprise, but the impact of government policies on currencies is typically a slow burner. Russia's devaluation was brutal and rapid, producing the kind of currency shock that's highly unusual, while Lehman's demise came in the middle of a true financial crisis that amplified market moves everywhere.

But that isn't to dismiss the precedents. All underscore the sense in which a country's currency is the transmission mechanism by which the markets render judgment on prospects for economic stability and growth. The widespread assumption is that Britain's financial foundations are secure and growth healthy. But despite low interest rates and continued quantitative easing, the risks are big. Britain runs a large current account deficit; if hot money were to flow out of the economy after a Brexit, the pound would be hurt. Britain's currency would be the most obvious target for the world to take aim at following a U.K. vote to leave the EU.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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