The currency exchange market has been particularly volatile of late with the pound falling to a six-month low against the US dollar earlier this week. So, what is GDP, what does it mean and why does it affect currencies?
GDP is one of those few pieces of business news that can move currencies decisively in one direction or another. Last month the International Monetary Fund (IMF) warned that the UK’s GDP was likely to show the smallest rise of any major economy, and the pound fell to its weakest point for two years.
Clearly, for anyone with a major property transaction overseas or with bills to pay in a different currency, these three letters, GDP, can cost you a lot of money.
What is GDP?
GDP stands for Gross Domestic Product or as the Bank of England puts it, “GDP is a measure of the size and health of a country’s economy over a period of time (usually one quarter or one year).”
So, when we say GDP, we really mean the size of the economy. It is also, and this is crucial for currencies, used to compare how well different countries are doing economically.
GCP is calculated by the governmental agency the Office for National Statistics every month, by effectively counting up how much everyone, including the government, is spending.
Since it measures the country’s economic health – everything from the level of construction to how much we’re spending on the high street or on going out – international investors take a keen interest.
Some things can have an interesting and surprising effect. For example, the football World Cup which kicked off in November 2022 boosted GDP as millions of people watched in local pubs. Then, when England were knocked out, this contributed fractionally to GDP falling in December. The closing of business following the Queen’s death in September also negatively impacted GDP, while a heatwave in May can send the public out to buy summer clothes and boost GDP.
As different months can be affected by one-off events, it is usually looked at quarterly. Even so, some events can have an outsized effect on GDP, such as the quarter of the first Covid-19 lockdown, when GDP fell by 15%. On the other hand, high government spending on the Test and Trace system in the later stages of the pandemic boosted GDP.
GDP and exchange rates
There are several ways in which GDP affects currency exchange rates. Firstly, there is a direct effect. If a country is doing badly economically, international investors don’t want to put their money here and demand for sterling falls, taking the exchange rate down.
Hence the IMF’s warning that GDP in the UK is likely to be the worst of any major industrialised power, weakened sterling.
A ‘recession’ is defined by economists as two successive quarters of negative growth, i.e. GDP falls. The country’s economic policymakers do not want that to happen.
A recession tends to bring with it unemployment and worries over job security, smaller pay rises, less business investment and lower government spending (controversially, as some economists believe that recessions are precisely when the government needs to be spending more).
Then there are secondary effects. For example, the Bank of England is charged with controlling inflation, but also keeping the economy growing. If GDP is falling as money is squeezed out of the economy by interest rate rises, the Bank of England is likely to ease up on interest rates and the currency is likely to weaken. You can read more about interest rates and their effect on exchange rates here.
GDP and your move abroad
Volatile exchange rates and the prospect of recession can make the financial side of moving abroad difficult to plan.
Firstly, there are the worries over job security and wage levels which might put one off buying a holiday home abroad just yet. The government might not, for example, be able to increase salaries in the public sector, or pensions and benefits.
Then there are worries over exchange rates, vital for anyone making large overseas transactions such as for a property abroad.
Recent GDP figures
This morning we heard Gross Domestic Product (GDP) for the UK, which showed that the British economy grew slightly more than expected in the year to the end of June, at 0.6% instead of 0.4% as previously believed. Indeed, today’s GDP release from the Office for National Statistics (ONS) shows that the UK economy grew faster than other G7 rivals in 2022 and also in 2021 (with 8.7% growth).
However, economic performance grew less in the second quarter than in the first quarter.
GBP/USD: the past year
How will the Bank of England react?
The Bank of England’s (BoE’s) aim is to return inflation to the official target of 2%, from the 10%-plus it has been in recent months. However, it also has to keep more than half an eye on GDP and the health of the economy as a whole, with their effect on things like jobs.
If high inflation was judged to be the main culprit behind a contraction in GDP, then the Bank’s Monetary Policy Committee (MPC) would need to consider ways to boost the economy. Indeed, some of the nine members of the MPC are already voting against further rates hikes.
If The Bank pauses or even reverses interest rate rises to boost the economy, investors might not be as keen to pour funds into the pound as they’d get a lower return. This would mean the demand for sterling would fall and the currency would weaken. However, with inflation being less high than in previous months and the recent GDP data being quite mixed, the BoE isn’t likely to make any big decisions or slow down on interest rates just yet.
What this all means for your overseas property purchase
Although sterling has strengthened recently, and GDP and the avoidance of recession have contributed to that, the bottom line is that currency markets are inherently volatile and it’s impossible to predict where the pound will be in the coming days and weeks.
Additionally, if December’s GDP fall is repeated in the coming months, and is more significant than rival economies such as Germany, France and the USA, the pound is likely to fall further.
We advise taking a risk management approach to your currency to ensure that your budget is protected from unexpected volatility. Get in touch with one of our team on 020 7898 0541 to discuss your options. We’d be delighted to help.
