It is expected that weakness of the sterling (GBP) will continue as the UK economy continues to weaken, despite the subtle change from UK policy makers about sterling. Similar to the US Federal Reserve they were initially in favour of a weaker currency.

However, the US competent authority changed its outlook in early June 2008, contending that a weaker USD was inflationary. The UK counterpart seems to keep its options open irrespective of the inflationary arguments in relation to a weaker GBP. If inflation were to soften, then a weaker GBP will be fashionable. Notwithstanding this, the likelihood is that GBP will deteriorate regardless of the UK policy makers' viewpoint.

The UK fundamental outlook continues to decline and the risk of recession is mounting. Although the occurrence of recession is contentious, the sharp slowing of the UK economy is evident. As a result, the Bank of England is assumed to be more in favour of a weaker GBP to bring equilibrium to the economy. This will benefit exporters, giving rise to a better trade position for the UK. This argument has been put forward mainly by the Bank of England.

The idea that a lower GBP can help promote rebalancing of total demand requires some cross-examination.

It is believed this would work better if external demand was relatively stronger and UK inflationary pressures were lower. Nevertheless, since other economies are weakening and UK inflation is high, further GBP weakness might worsen matters. This position is substantiated by the fact that the Bank of England has already established that GBP weakness is an inflationary risk and that the one-sided rebalancing view is being diluted. GBP is likely to weaken further, but the other parts of the equation may need to think differently about how the Bank of England views GBP.

Recent UK PMI (Purchasing Managers' Index) surveys raise some concern. The service sector PMI for June 2008 dropped to 47.1, which was the lowest level of the index since 2001. The manufacturing PMI fell to 45.8 in June 2008, from 49.5. Following the disappointing results featured in the PMI surveys from manufacturing, construction (38.8) and services (47.1), there exists the high probability of a GDP tightening in the second quarter of 2008. However, activity in the early weeks of Q2 suggests an expected growth of 0.1 per cent (quarter-on-quarter) in Q2 before a definite contraction in the third quarter.

While growth in the UK is on the downturn, price pressures are on the rise. Input prices in the service PMI reached a new high, with output prices edging up. Like the manufacturing sector, the degree of pass-through into output prices has been relatively limited, and the risk is that output prices start to rise further.

Taking into consideration that the UK growth-inflation trade-off is weakening, the suggestion of an additional GBP weakness to help re-balance the economy seems to create a problem. Further GBP weakness could give rise to higher import prices, the outcome of which would necessitate a worse overall inflation outlook in the UK. This presents an uncomfortable situation for the Monetary Policy Committee (MPC).

The weakness of the GBP has helped UK exporters to a certain extent but so far has not led to a significant improvement in the UK trade deficit. It can be assumed that there is a delayed effect before GBP weakness makes the UK much more competitive. At a time when global growth is slowing, the benefits that a weak GBP can provide to exporters are minimal. A slowing of the UK's main trading partners will mean less demand for its exports, even if GBP is weak.

It can be noticed that the MPC changed its attitude about GBP. After the rate cut by the Bank of England in February, the MPC placed greater emphasis on a weaker GBP being part of the growth solution. Following the rate cut in April, the MPC did not mention how GBP could help re-balance the economy but only argued about the inflationary impact caused by a weak GBP. It is a subtle change in attitude regarding the currency, but indicative where the MPC's new concerns lies from a currency perspective. If the MPC is concerned about inflation, then its view that GBP should be part of the recipe to re-balance the economy could be less forthcoming.

The question still remains whether the GBP should not weaken anymore. And the most probable answer is that, it is not necessarily to do so. Many central banks prefer a stronger currency in inflationary times but there is no assurance that their objectives are met. Due to the inflation situation the policy makers have refrained from calling for outright GBP weakness. And still, the underlying problem remains: the UK economy is slowing dramatically. Thus, the likelihood is that sterling weakness will materialise.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.