Paribas CLEER is our medium-term FX model which estimates the fair
value of a currency based on cyclical macroeconomic fundamentals (CLEER
stands for CycLical Equilibirum Exchange Rate). The fundamental input
factors into CLEER are macroeconomic variables such as inflation
differentials, relative growth, relative interest rates and the broad
basic balance of payment (BBBoP). The BBBoP is currently one of the most
important variables for the GBP, and allowed us to conduct scenario
analysis based on the potential outcomes of the UK’s current and capital
We use CLEER to provide scenario analysis based on outcomes for the UK’s capital account:
1. Best-case: If
the inflows into the UK economy continue and the BBBoP remains at
around 12.5% of GDP, the CLEER model estimates GBPUSD should stand at
around 1.46. Incorporating a mild impact from the BoE’s QE programme, the fair value for the pair is around1.39.
2. Worst-case: In
previous periods of economic or financial slowdown (1991, 2001/2 and
2008/9), the UK’s BBBoP reached extreme lows of around -10% of GDP. A
return of the UK’s BBBoP to this level would correspond with GBPUSD
trading around 1.35 acccording to CLEER. Incorporating an ongoing large
impact of the BoE’s QE programme, the ‘worst-case’ level for GBPUSD is around 1.22, ie close to the trading level in recent days.
3. Middle ground: Under
the scenario of a balanced BBBoP, with financial inflows declining
markedly but still covering the UK’s large current account deficit, the
CLEER stands slightly below 1.40. Incorporating on ongoing impact of QE
in line with the average impact of previous rounds of QE on the GBP’s
valuation, the ‘middle-ground’ estimate is around 1.33.
In conclusion, our
CLEER analysis provides a quantitative assessment that the decline of
the GBP in recent weeks appears to have reflected the ‘worst-case’
scenario being priced into the currency, both in terms of a substantial deterioration of capital flows into the UK, and the impact of BoE QE on the GBP.
light of the GBP’s extreme short positioning and very cheap valuations,
we continue to see scope for the GBP to bounce on positive news
Since we reiterated our 3-month target of 1.20 for GBP/$, Cable has fallen sharply to within striking distance of our forecast*.
Given how much Sterling has now fallen, much of the market dialogue revolves around the idea of “fair value”,with
many making the point that the Pound is now very cheap. Indeed, on our
fair value model for exchange rates, something we call GSDEER, GBP/$ is
now slightly more than one standard deviation cheap, the first material
undervaluation in a long time (Exhibit 1). The problem is that GSDEER
and models like it tend to generate estimates for fair value that are
essentially long-term moving averages of the exchange rate, which means
that they do not allow for structural breaks of the kind that the
referendum and the rising odds of a “hard” Brexit
clearly represent. In other words, fair value in models such as GSDEER
has likely jumped lower, although the extent to which this is the case
is difficult (and somewhat arbitrary) to model.
We therefore pursue a different approach, estimating
the kind of exchange rate adjustment needed for the UK current account
deficit to shrink to some target level. This kind of model, also called the macro-balance approach,
is used by the IMF in its exchange rate valuation assessment across
countries. The model generates an estimate for the underlying current
account, closing the domestic and foreign output gaps and feeding
through lagged effects of exchange rate changes.
Exhibit 3 shows our estimates for the underlying (cyclically
adjusted) current account (blue line), together with the actual current
account (black line). Exhibit 4 maps the difference in these two lines
into the contributions from closing the domestic and foreign output gaps
and feeding through lagged exchange rate changes.
The black line in Exhibit 5 shows the evolving exchange rate
assessment for the British Pound using this approach. It shows the move
in the real effective exchange rate that is required to bring the
underlying current account to -1.5 percent. Given the sharp devaluation
that has already occurred, this number is now -10.3 percent, i.e., Sterling
would have to fall another 10 percent for the underlying current
account to go from its current level (-3.0 percent) to -1.5 percent.
The grey area around the black line gives the upper and lower bounds
for the exchange rate adjustment if we assume that the underlying
current account needs to move to -3.0 percent and 0.0 percent,
respectively. In the former case, given that the underlying current
account is already at -3.0, the required GBP move weaker is essentially
zero, while it is closer to 20 percent if the current account needs to
close entirely. These estimates are obviously subject to large
As we note above, the trade elasticities we use may be too
optimistic, which would mean that the required Sterling fall is bigger
than we show here. It is also quite possible that the current account
doesn’t need to shrink as much, if the UK is eventually able to
negotiate a “soft” Brexit. That said, our
main result is that – even with the large declines that have already
occurred – the trade-weighted Pound is still around 10 percent
overvalued if a smaller current account deficit is the norm going
forward. In short, Sterling is not yet cheap.